Spring 2012 Issue

Columbia Economics Review

Follow the FedThe International Spillovers of U.S. Monetary Policy

Capital Market FailureFinancial Intermediation in China

Bonds, European Safe BondsAn Interview with Professor Ricardo Reis

Spring 2012Vol. II, No. 2


2 Spring 2012

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T A B L E O F C O N T E N T S

Features4 Rainy Day Politics

Latin American Countercyclical Fiscal Policy and the 2008 Financial Crisis

9 Betting with your BrainBehavioral Economics and Gambling Safeguards

Interviews12 Bonds, European Safe Bonds

An Interview with Professor Ricardo Reis

Theory & Policy

Business & Finance

15 Follow the FedThe International Spillovers of U.S. Monetary Policy

21 Tragedy of the CucumbersSea Cucumber Overfishing in the Galápagos

24 Capital Market FailureFinancial Intermediation in China

28 Recasting the ModelSpeculation in the Housing Market

Rainy Day PoliticsAmerican Countercyclical Fiscal Policy

and the 2008 Financial Crisis

Matt Getz

Columbia University

The recent global financial crisis hit the developing world in September 2008. For Latin America, a region all too familiar with rapid downturns, this new global slump presented a serious threat to eco-nomic, political and social stability. Yet at the onset of the crisis, many observers were enthusiastic about the region’s out-look. Of particular interest was a new-found capacity for crisis-averting counter-cyclical policy. In the past, Latin America’s

overdependence on foreign financing and fiscal profligacy meant that sudden stops would trigger severe contractions during downturns (Gavin & Perotti, 1997). But throughout the first decade of the 2000s,

many Latin American countries moved toward exchange rate flexibility, inflation-targeting policies, stronger central banks, fiscal balances and decreased public debt (IDB, 2008; Fernández-Arias & Montiel,

2009). These macroeconomic reforms led observers to a common conclusion: Latin America now enjoyed newfound “space” for countercyclical policy.

This paper examines fiscal space in Latin America in relation to the 2008 financial crisis and five-year economic boom that preceded it. It analyzes an important question: have Latin American countries developed sufficient macroeconomic ca-pacity to escape the pro-cyclical crises of their past? What circumstances mediate the ability to implement these stimulus programs? Through a comparison of sev-eral countries, I attempt to elucidate the

pathway through which Latin American governments have accumulated or deplet-ed fiscal space.

As in many developing countries, 1998 marked a severe drought of capital in-

flows to Latin America, spawn-ing debt crises, inflation, and slow or negative growth. These years of down-turn marked a watershed with respect to the po-litical economy of the region; the

crises and stagnation, along with dissat-isfaction with the International Monetary Fund (IMF), would create fundamental changes to domestic politics and econom-ic policy for years (Cardim de Carvalho, 2010).

The severity of the late 1990s was out-paced by the boom period that began in 2003, driven by an exceptional combina-tion of abundant financing and high com-modity prices across the agricultural, min-eral and energy sectors (Ocampo, 2009). Average annual growth rates jumped to 6% between 2003 and 2007 as Latin Amer-ica rode the wave of exuberance (IDB,

...have Latin American coun-tries developed sufficient

macroeconomic capacity to escape the pro-cyclical crises of their past? What circum-stances mediate the ability

to implement these stimulus programs?


4 Spring 2012

2008, p. 3).But as of September 2008, all of the fac-

tors formerly responsible for driving the boom had reversed severely. First, inter-national trade contracted drastically in late 2008 after growing by 9.3% per year in 2003–06. Second, commodity prices plum-meted across the board (Ocampo, 2009, pp. 706-7). Finally, capital inflows to the region ground to a halt by the end of 2008 (ECLAC, 2009a, p. 21). Time was up: the

boom had ended.This paper works from the recognition

that fiscal policy can play a stabilization role in an economy by stimulating aggre-gate demand during downturns (Alberola & Montero, 2006). By engaging in fiscal and monetary activism, governments can mitigate the impacts of a crisis, sustain the purchasing power of the middle class, and avert social backlash.

At the onset of the crisis, political lead-ers in Latin America shared a general in-centive, on both symbolic and material grounds, to implement countercyclical fiscal policies. Politicians would want to demonstrate to voters that they took im-mediate action to the crisis. By attempt-ing to stimulate aggregate demand, they could reduce he probability of a larger-scale downturn, which would be pun-ished later through retrospective voting. Yet while I assume that all governments, to some extent, shared this baseline incen-tive to implement countercyclical policy, in practice each government differed in its capacity to do so. During the run-up to the crisis, each government made choices that either contributed to or limited its ability to respond with stimulus programs. My contention is that the size and extent of

fiscal stimulus programs in response to the 2008 crisis was conditioned by each

government’s actions during the 2003-07 boom.

Governments can fund countercyclical fiscal packages if they have savings or if they can access loans. But for better or worse, conditional loaning practiced by the IMF in the 1990s led to hesitation to-ward accepting support from that body. The challenge in the region therefore be-

came “to find ways to deal with the possi-bility of capital flows reversals other than appealing to the IMF for support” (Car-dim de Carvalho, 2010). From 2003 Latin American governmentFrom 2003 to 2007, Latin American governments could have increased revenue streams from their ex-port booms through taxes or state-owned companies (Ocampo, 2008). If govern-ments could also reduce discretionary ex-penditures, then they could lower sover-eign debt and run healthy fiscal balances that could fund stimulus programs or at-tract loans in the time of a crisis.

Governments could also prepare for downturns by accumulating international reserves from foreign liquidity inflows

generated by commodity exports (Cardim de Carvalho, 2010). These reserves could be used as an “alternate financing modal-ity” to finance fiscal deficits (Fernández-Arias & Montiel, 2011, pp. 306-8). Latin America witnessed extensive accumula-tion of reserves into “rainy day funds,” sovereign stabilization funds designed to account for fluctuations in capital inflows or commodity prices (Cardim de Carval-ho, 2010).

A critical distinction must be made with regard to international reserves. Both Car-dim de Carvalho (2010) and Griffith-Jones and Ocampo (2008) argue that the current account balance should play a central role in considering the use value of interna-tional reserves. When reserve accumula-tion is driven by a current account surplus, these reserves represent an accumulation of wealth; these reserves are owned, ready to be put to use. During a current account deficit, the reserves merely reflect an in-crease in foreign loans; they are borrowed liabilities (Griffith-Jones and Ocampo, 2008, p. 16). For international reserves to be used as stabilization funds, they must be accumulated with a current account surplus as their impetus.

The use value of international reserves is also altered by fiscal sustainability. In the eyes of the governments that control them, these rainy day funds have a value that is relative and based on the perceived risks and benefits of their use. During an economic crisis, countries will have an incentive to tap into these funds to fight for electoral favor. Yet governments are also constrained by concerns with credit-worthiness. If a government is running a fiscal deficit with high sovereign debt, its leaders will worry that by depleting the reserves today, they risk leaving them-selves vulnerable to even worse crises in the future. In other words, countries might not spend their “rainy day funds” today if they fear a torrential downpour tomorrow. Past experiences with financial meltdowns have made many Latin Ameri-can countries particularly debt intolerant in this regard. I expect that these “owned” international reserves will be used to fi-nance fiscal deficits only insofar as the risk of using them is perceived to be lower than the risk of holding them.

Of course, governments in the region may very well not have saved during the boom. Sociopolitical pressures dur-ing times of plenty can create political economy distortions that prompt pro-cyclical spending (Calvo & Talvi, 2005). A government that gives into spending pressure during a boom may find that it has handicapped itself when a crisis hits,

From 2003 to 2007, Latin Ameri-can governments could have

increased revenue streams from their export booms

through taxes or state-owned companies.


Spring 2012 5

rendering it incapable of responding with countercyclical policy despite its incentive to protect vulnerable constituencies (Talvi & Végh, 2005).

I hypothesize that the size and extent of fiscal stimulus policies will be determined by the combination of two variables: the accumulation of owned international re-serves and fiscal sustainability. Larger stockpiles of international reserves and fa-vorable fiscal sustainability will result in the largest stimulus programs, as govern-ments tap into their reserves with reason-able confidence. A country with reserves, but doubts about sustainability, may man-age to produce some stimulus programs,

but these are likely to be limited by con-cerns of long-term solvency and will be smaller. Lastly, countries with smaller pools of international reserves and greater concerns with debt sustainability are ex-pected to enact little to no fiscal stimulus programs.

In selecting countries for this study, I have chosen the seven largest Latin Amer-ican economies, or the LAC-7: Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. Together, these countries account for over 90% of Latin America’s GDP (IDB, 2008, p. 2). These nations’ size and resources fundamentally separate them from the rest of Latin America in terms of history and tendencies.

The LAC-7’s fiscal space at the onset of the crisis is a multidimensional considera-tion dependent on many factors (Polito & Wickens, 2005). Rather than rely on one measure alone, I have collected a series of data that capture various components of a country’s long-term prospects for sustain-ability. The first is J.P. Morgan’s Emerging Market Bond Index (EMBI), which serves as a market-based indicator of available fiscal space. Second, I have included the gross public debt of each central govern-

ment. Third, I include the fiscal balance of each government, recognizing that high deficits are especially troubling for the future. Fourth, I include Fernández-Arias and Montiel’s “required structural adjust-ment” that would be necessary for each country to maintain its current debt-to-GDP ratio (2009, p. 27). Finally, I perform a basic calculation of total public expendi-tures over public revenues in each coun-try, which roughly measures how much each government has saved or spent (val-ues over 100 show greater expenditure than revenues). I have collected each of these measures into Table 1 below, which gives a broad overview of each country’s

long-term sustainability in 2007.It is no surprise that Chile stands out for

its fiscal sustainability in every measure, given Chile’s good reputation in interna-tional financial circles. Second place goes, without question, to Peru. Again, these favorable figures are not entirely surpris-ing, considering Peru’s adoption of a Fis-cal Responsibility and Transparency Law at the turn of the century. The clear advan-tage of Peru and Chile in these measures reflects Ocampo’s assessment that only Peru and Chile exercised countercyclical restraint throughout the boom.

Conversely, there is Chávez’s Venezue-la. Over 80% of Venezuela’s total exports are oil products (Jiménez & Tromben,

2006, p. 62), and while exports led to an average growth rate of over 11% between 2004 and 2007, there was no improvement in fiscal management during that time. As Venezuela’s pro-cyclical government ex-penditure and enormous required struc-tural adjustment indicate, Chávez’s gov-ernment greatly spent beyond its means. Venezuela should have the greatest con-cerns with debt sustainability.

Argentina is another country that should have serious doubts about access

to foreign financing. Since its 2001 default, Argentina has been regarded with suspi-cion in EMBI risk spreads. Most troubling, it has by far the highest debt-to-GDP ratio of the LAC-7. Considering “recent upward trend in public spending” in anticipation of the 2007 elections (Ocampo, 2007, p.26), this trend calls the country’s sustainability further into doubt.

Mexico is a complex case. Its EMBI spreads and debt-to-GDP ratio would suggest that its leaders could afford to be optimistic, yet its required structural ad-justment is the second most severe after Venezuela. One must remember that Mex-ico has the greatest single market overde-pendence among the LAC-7; it sent 82% of its total exports to the US in 2007 (Rojas-Suarez, 2010, p. 6). At the onset of the cri-sis, the Mexican economy should expect a more severe contraction than more di-versified countries. So while some of the 2007 figures indicate room for optimism, in practice the Mexican government may have had reason to worry that foreign fi-nancing would be available as the down-turn continued.

This leaves Colombia and Brazil, re-markably close in each measurement. Both countries had enacted fiscal responsibil-ity laws to increase investor confidence (Singh, 2006, p. 9). Brazil and Colombia are two countries in which fiscal sustain-ability may not be of immediate concern, but policymakers in both can be expected to be mindful of these constraints.

I group the LAC-7 into three categories of fiscal sustainability. Peru and Chile should have been unconcerned with their creditworthiness at the onset of the cri-sis. Mexico, Brazil and Colombia should display reasonable concerns with sustain-ability. Lastly, the governments of Ven-ezuela and Argentina likely felt highly constrained by creditworthiness.

Reserves held in foreign currencies can be measured in dollar amounts or as a percentage of total GDP. In Tables 2 and 3, I display both measures between 2003 and 2007.

As Table 2 shows, international reserves increased—to varying degrees—in every country between 2003 and 2007. These increases were frequently heralded as positive steps for countries in the region. However, as previously mentioned, it is useful to distinguish between interna-tional reserve accumulations under cur-rent account surpluses and deficits. Table 4 shows each country’s annual current ac-count balances between 2003 and 2007.

Estimating the effect of the current ac-count on reserve accumulation is complex. I propose a simple estimation by using the


6 Spring 2012

current account surplus as a multiplier effect on reserves. For each country and year, I multiply the international reserves (in dollar amounts) by the current account balance (as % of GDP). This index esti-mates an adjusted size of reserves as mod-erated by the current account; the larger the surplus, the more likely these reserves will reflect “owned” assets rather than in-creased foreign liabilities. I have included this index in Table 5.

A closer examination of the numbers may reveal the utility of the index, start-ing with Argentina and Venezuela. These countries enjoyed only the third- and

fourth-largest pools of international re-serves in 2007, but their current account surpluses were spectacular. Of course, it should be noted that Venezuela’s 8.8% drop in reserves between 2006 and 2007 is indicative of pro-cyclical depletion of these funds, which calls Venezuela’s ac-cess to reserves into question. Yet both had unquestionably accumulated a good deal of these “owned” international re-serves.

Conversely, while Brazil had by far the most international reserves, this figure is less impressive when adjusted for the size of Brazil’s economy and considering Brazil’s explosive capital account surplus toward the latter half of the boom years. Brazil’s capital account surpluses in 2006 and 2007 reflected a rapid inflow of ex-ternal loans. These flows of “borrowed” assets explain the country’s leap in inter-national reserves by 2007. Thus, there is great reason to believe that these funds would not have been readily available to finance countercyclical stimulus pro-grams in Brazil.

Chile, on the other hand, features inter-national reserves that look moderate in dollar amounts. Yet like Argentina, Chile ran a steady current account surplus af-ter 2003. More importantly, the Chilean government had created two sovereign stabilization funds, together worth about $21.9 billion (Ocampo, 2008, p. 9). All fac-tors considered, therefore, Chile falls with Argentina as having the greatest access to international reserves to fund countercy-

clical policy.Peru is another country for which re-

serves levels are promising considering the current account and government pru-dence. Peru’s current account surpluses after 2003 suggest that reserves accumu-lation was set in motion by increases in commodity exports. Like Chile, the Peru-vian government in 2003 created a Fiscal Stabilization Fund to use reserves accu-mulated by the government from capital inflows on exports (Jiménez & Tromben, p. 77).

Last, there are Colombia and Mexico. Throughout the boom period, both ac-

cumulated their international re-serves under a steady current ac-count deficit. But both countries also established sovereign stabili-zation funds to ac-cumulate reserves from oil exports. These sovereign

funds were considered to be less substan-tial and effective than those of Chile and Peru (Jiménez-Tromben, 2006, p. 81), but they could nevertheless account for some flexibility at the onset of the crisis. In gen-eral, both Colombia and Mexico had ac-cumulated a fair amount of international reserves in sovereign funds, but under conditions that call into question their abilities to fund fiscal deficits during a sudden stop.

I group the countries into four categories based on the nature of their international reserves. Argentina and Chile lead the pack. Peru’s sovereign fund greatly con-tributes to its capacity to use international reserves; I place it in the second-highest category. Venezuela joins Peru in this sec-ond category. In the third category are Colombia and Mexico; while their reserve accumulation was modest, both countries had sovereign stabilization funds, indi-cating that the governments have some immediately deployable reserves. Lastly, I place Brazil alone in the last category. Unlike Colombia and Mexico, the Brazil-ian government had not established sov-ereign stabilization funds in preparation for a downturn. I judge Brazil to have the least immediate access to international re-serves for deficit financing.

Large pools of international reserves will result in large fiscal stimulus pro-grams only insofar as concerns with long-term solvency do not limit governments’ willingness to tap into these funds. I visu-ally express this hypothesis by arranging

both variables along separate axes and populating the field with countries based on my analysis (see Figure 1).

Moving up and to the right, the size of fiscal stimulus programs in reaction to the crisis should increase. This predicts that Chile will enact the largest stimulus pro-gram, with Peru having the second larg-est. With regard to the remaining coun-tries, I believe that concerns with debt sustainability change a government’s per-ception of the risks of using the rainy day funds. In other words, while international reserves are the financing source for coun-tercyclical spending programs, debt sus-tainability is the condition that allows or restrains the use of those funds.

Consider Argentina. I predict that Ar-gentina’s aversion to debt and debt con-cerns fundamentally alter the use value of reserve pools by increasing the perceived risk in using them today rather than sav-ing them. The same goes for Venezuela: despite large international reserves, I ex-pect concerns with debt sustainability to incentivize saving the funds rather than using them. Argentina and Venezuela are expected to have the smallest fiscal re-sponses to the crisis.

While Brazil, Colombia and Mexico each should have similar expectations of debt sustainability, the latter two had estab-lished sovereign stabilization funds by the time of the crisis, whereas Brazil did not. These stabilization funds offer procedures for countercyclical spending and could be expected to have a significant effect. Co-lombia and Mexico should have larger fis-cal stimuli than Brazil.

To review, I predict that the LAC-7 fiscal stimulus programs in response to the 2008 crisis should fall, from largest to small-est, as follows: Chile, Peru, Colombia and Mexico, Brazil, Argentina, and Venezuela.


Spring 2012 7

For each country, I include only pro-grams enacted through 2009, thereby isolating the initial fiscal responses to the crisis. Figure 2 shows that, in order from largest to smallest countercyclical fiscal

programs, the LAC-7 are: Chile, Peru, Colombia, Argentina, Mexico, Brazil, and Venezuela.

Despite Chávez’s populist rhetoric, Ven-ezuela was forced to resort to blatantly procyclical cutbacks during the crisis. The severity of concerns with long-term debt sustainability made countercyclical policy untenable. Venezuela provides a strong anecdotal case that spending during up-turns will limit a government’s ability to enact countercyclical fiscal policy during downturns.

At first glance, the size of Argentina’s stimulus programs seems to refute my hypothesis. But there is a crucial miss-ing piece of information. Argentina was, in fact, hesitant to tap into its funds; its international reserve holdings slightly increased by the end of 2009. Instead, to finance its fiscal deficit, the Argentine government instituted a forced nationali-zation of private pension savings (ECLAC, 2010b). The risk of using these funds was judged to be too high, and the Kirchner government sought another heterodox way to finance its deficit.

The puny size of Brazil’s stimulus pack-ages may have shocked those who ar-gued that international reserves were the determinative factor of Latin America’s progress. But as this paper has argued, both the type of reserves accumulated and a country’s concerns with sustainabil-ity can alter these reserves’ readiness for

spending. Colombia, Mexico and Brazil accumulated their reserves under low-to-negative current account balances, but while Colombia and Mexico saved sov-ereign stabilization funds, Brazil lacked

a similar institution. The disparity in fis-cal stimulus programs implemented by Brazil on one hand and Colombia and Mexico on the other suggests that, all else being equal, sovereign wealth funds with stabilization as an institutionalized moti-vation may motivate policy action where the mere accumulation of reserves does not. Interestingly enough, the Brazilian government in 2009 began accumulating government revenue in the multi-billion dollar Sovereign Fund of Brazil (FSB), de-signed explicitly for stabilization during financial crises. Brazil may have learned a lesson from its neighbors in the region: a sovereign wealth fund, funded by com-modities, can be of great use for enacting stabilizing countercyclical policy.

Colombia and Mexico, as predicted, both enacted moderate countercyclical fis-cal policies. Likewise, in Chile and Peru, sovereign stabilization funds of interna-tional reserves were accessed to finance spending increases and tax cuts (ECLAC, 2010b). As predicted, Chile’s programs were slightly larger than Peru’s. Thanks to fiscal surpluses and manageable debt, policymakers in both countries were able to tap into these funds without fearing disproportionately worse credit crunches in the future.

My findings suggest that some of Latin America’s countries may have indeed gained some critical fiscal space. By limit-ing the impulse to spend during booms,

Latin America as a region has avoided a large-scale economic collapse. Indeed, after a precipitous drop in 2009, growth rates for the LAC-7 countries (excluding Venezuela) rose to an average of 6.7% for 2010. Nevertheless, this macroeconomic improvement is limited and contingent. More importantly, countries must learn the correct lesson from 2008: it was not public spending in general, but rather countercyclical public spending (and the improvement of external conditions) that enabled growth to return. As Cárdenas and Levy-Yeyati (2011) discuss, it takes less political maneuvering to tap into rainy day funds than to renew counter-cyclical saving as conditions improve. As much as the 2003–2007 boom was an important test of restraint, the upcoming years will likely be even more important, as countries must cool off spending pro-grams and replenish their reserves. Coun-tries may have earned fiscal stability in 2008; but will they fight to keep it?

While international reserves provide a vehicle for financing stimulus in down-turns, these pools should not be the only means to procure financing; many of the regional and international financial in-stitutions were designed to stabilize the global economy by providing funds in a crisis. Given the IMF’s ruined reputa-tion, the role of other intermediaries—the Inter-American Development Bank and the World Bank—could be increased to provide credit lines at reasonable interest rates to smooth sudden stops. If organi-zations could commit to providing credit to emerging markets, then concerns with debt sustainability would play less of a prohibitive role with respect to interna-tional reserves.

Lastly, Latin America has the potential to provide for stability in the face of the business cycle, but only if its countries can consolidate the fiscal restraint displayed in bits and spurts between 2003 and 2007. As Rojas-Suarez (2010) argues, public sav-ings rates in Latin America are still too low, and governments in the region must find a way to sell renewed countercyclical restraint to their populations in anticipa-tion of the next downturn. But even with a healthy dose of skepticism, it is difficult to deny that Latin America has significant prospects for growth and stability in the foreseeable future. As fiscal space, trade diversification, and sovereign stabiliza-tion funds grow throughout the region, Latin America may be headed straight for stability.


8 Spring 2012

The debate over casino legalization in Singapore was dominated by questions considering the potential social costs that the city-state could incur. In particular, many were worried about the implications of problem and pathological gambling giv-en a locally situated casino. In a statement

at Parliament in 2005, Prime Minister Lee Hsien Loong framed the main issue behind casino legislation in Singapore: “Are the economic benefits worth the social and law and order fallout?”

The answer to the question was a difficult “yes” for the government of Singapore as a significant proportion of the population remained unconvinced. Prime Minister

Lee did not expect unanimous support, recognizing the lack of a clear general con-sensus. It was decided that mandating ca-sinos would do more good than harm in Singapore’s efforts to maintain itself as a world-class city. The casinos would pro-vide added attractions that drive tourism. Moreover, they represent an additional source of tax revenue. Currently, casinos are subject to a 15% tax on gaming revenue from regular players and a 5% tax on gam-ing revenue from premium players. Premi-um players are those who maintain at least $100,000 in Singapore Dollars in a deposit account with the casino. The gap in tax rates between premium and normal play-ers leads to an effective tax rate of approxi-mately 12%. Despite its benefits, the social costs of casinos still have to be addressed.

To mitigate potential social costs, the legalization of casinos under the Casino Control Act came with a host of mandatory social safeguards such as a controversial levy exclusive to citizens and permanent residents (PRs) of Singapore. The motiva-tion behind these safeguards is relatively easy to grasp; the implication of a locally situated casino is that Singaporeans “will gamble more, more people will get into trouble, and more families will suffer.” The economics behind such safeguards is also straightforward. Casinos create social

costs that remain unaccounted for in an unfettered market. The imposition of social safeguards is meant to reduce these social costs. More specifically, these safeguards primarily aim to prevent existing problem and pathological gamblers from further de-structive behavior and the development of new problem and pathological gamblers

Broadly speaking, the policy instruments that can be used to limit problem gambling fall under three categories: command safe-guards, pricing safeguards, and behavioral safeguards. Command safeguards, such as age restrictions and exclusion programs directly restrict entry to gambling venues. Pricing safeguards, such as the casino levy for Singaporeans and PRs, indirectly re-strict gambling by placing pricing barriers and disincentives. Behavioral and social safeguards such as patron education and media campaigns attempt to influence the decision making process of gamblers.

Since the opening of both casinos, there is almost no doubt that Singapore has in-curred additional social costs. H2 Gam-bling Capital, a British consultancy firm, has estimated that gambling losses in Sin-gapore have risen 53% from $924 to $1,413. Moreover, the firm expects this figure to increase to $1849 by the end of this year. Credit Counseling Singapore, a debt advi-sory center, has seen a significant increase

Betting with your BrainBehavioral Economics and Gambling Safeguards

Jun Liang YapNew York University

In a statement at Parliament in 2005, Prime Minister Lee

Hsien Loong framed the main issue behind casino legisla-tion in Singapore: “Are the

economic benefits worth the social and law and order fall-

out?”


Spring 2012 9

in the number of people seeking help for gambling debts. The local chapter of Crime Library, an international volunteer group, has reported a large increase in the num-ber of people seeking help to locate their spouses who have disappeared as a result of large gambling debts. In light of these in-creasing social costs, it is important that we reconsider how best to regulate the casino industry.

Of the three types of safeguards, behav-ioral safeguards are the least understood and the least explored. The field of decision making, especially with regards to gam-bling, is relatively new. Casino industries throughout the world are currently subject to limited behavioral safeguards and those in Singapore are no exception. Currently Singapore casinos are required to comply with only two behavioral safeguards un-der the Casino Control Act (CCA). Under the CCA 109-(1), casinos are prohibited from installing automatic teller machines (ATMs) within their premises. Doing so helps to reduce the destructiveness of gam-blers’ dynamically inconsistent behaviors. Context has an effect on behavior; prohibit-

ing ATMs within casino premises reduces the temptation to withdraw money and gamble more. Also, under the CCA 106-(1), all casinos must engage in patron educa-tion, the act of helping gamblers make bet-ter decisions. This may include displaying problem gambling help services or even in-terventions by casino staff who are trained to recognize problem gambling behavior. Given the limited knowledge of gambling behavior, an obvious question hangs in the air: Can anything be done to make these behavioral safeguards more effective, or should new ones be introduced?

The first step towards the implementa-tion of effective behavioral safeguards is a solid understanding of gambling behavior. A recent report for the South African Re-sponsible Gambling Foundation makes a bold but insightful claim:

“There is only one general way to try to make progress with respect to confused and conflicted intuitions on the proper goals and norms of policy around prob-lem gambling. This is to conduct scientific research that attempts to understand what motivates people to gamble, and why some

people find it difficult or impossible to gamble within controlled and reasonable limits.”

Behavioral economics offers important insight into this topic. Gambling behavior is not rational in the economic sense of the word: rationality in economics implies that people behave in ways that maximize their own welfare and it would be a mistake to as-sume that all gamblers do so. Uncontrolled gambling routinely ruins lives. Behavioral economics, the study of “economic behav-ior beyond the traditional simple economic models of constrained maximization with purely economic objectives (consumption / profits),” offers a useful inroad to the expla-nation of gambling behavior.

What follows is an explanation of how behavioral economics could possibly have an impact on crafting more effective social safeguards. It first provides a behavioral economics interpretation of patron educa-tion before highlighting exactly how be-havioral economics could help create better policies. It then describes one promising way behavioral economics can enhance patron education. Lastly, it discusses very briefly further applications of behavioral economics on the social safeguards.

Under the CCA 106-(1)-(b)-1, all casinos must display prominently “the advice or

information concerning those rules (casino game rules), the mode of payment of win-ning wagers and the odds of winning each wager.” These requirements attempt to re-duce the social costs associated with this market failure by increasing the amount of information available. Patron education facilitates greater transparency through-out casinos and helps patrons make better gambling decisions. In terms of behavioral economics, patron education is perhaps best understood as an attempt to make gamblers more cognizant of and more re-sponsive to the expected losses of wagering money in a casino.

Probabilistic discounting refers to the rate at which a person’s valuation of a certain game of chance falls relative to the rate at

Gamblers routinely face probabilistic decisions and re-cent studies have shown that

gamblers tend to discount rewards less steeply, and thus

at a lower rate, than non-gamblers.


10 Spring 2012

which the probability of winning that game decreases. All else equal, all people would value a 90% chance of attaining $100 more than a 70% chance of attaining the same amount. As the probability of attaining the $100 falls, the value an individual ascribes to this game will decrease hyperbolically. Hyperbolic decrease is a graphical term, describing an accelerating fall in one vari-able, in this case the valuation of a game, as another variable, the probability of at-taining the reward, decreases. The more a person’s valuation of a game of chance falls relative to the falling probability of attain-ing its reward, the higher the probabilistic discount rate. Thus the higher a person’s discount rate, the more sensitive the person is to risk. Of course not everyone discounts at the same rate and not everyone is equally sensitive to risk.

Compared to research available on tem-poral discounting, the rate at which a per-son’s valuation of a reward falls relative to the time horizon of attaining that reward, there is a dearth in research on probabil-istic discounting. However, the concept of probabilistic discounting could improve our understanding of gambling behavior. Gamblers routinely face probabilistic deci-sions and recent studies have shown that gamblers tend to discount rewards less steeply, and thus at a lower rate, than non-gamblers. This means that as the probabil-ity of attaining a reward falls, a gambler’s valuation of that potential reward falls at a slower rate than that of a non-gambler, though there is not yet an established con-sensus on this conclusion. A 2009 study found that clinically defined pathological gamblers have significantly lower proba-bilistic discount rates than their matched controls. Another study published in 2003 found that undergraduate students who were gamblers discounted probabilistic rewards less steeply than their controlled counterparts. These and other studies do more than point towards the intuitive idea that pathological and frequent gamblers (and perhaps potential pathological gam-blers) are less sensitive to risk. Having a method of quantifying risk sensitivity is valuable. It may allow for controlled ex-periments on gambling behavior to inform new behavioral safeguards.

One question for policymakers, then, is whether patron education helps gamblers to discount probabilistic rewards (in casino games) more steeply. This is a precise ques-tion that can be answered through experi-ments in behavioral economics measuring the effects of different information on prob-abilistic discount rates.

Though essential, odds displays alone at casinos do not do enough to help patrons

make better decisions. Currently casinos are not required to display any informa-tion on the probability of winning a par-ticular round of wagering. Rather, they are required to display the “odds of winning” which refers only to the payout of winning a specific wager. For example, the roulette table will display an offer of 1-1 odds for the color black. This means that a gambler would receive a payout of $2 for every $1 wagered should he happen to place a win-ning bet on the color black. Displays of the odds of winning are ambiguous and can confuse patrons without a basic grasp of the mathematics behind gambling. The odds of winning can be mistaken for the probability of winning a particular round of wagering in a particular game. For the most part, though, patrons of casinos are given information on how much they stand to win but not how often they stand to win. This gap in information between payout and probability could encourage more harmful gambling decisions as it enhances the saliency of rewards. Gamblers could actually be making decision after decision that lead them to financial ruin without a sense of how often they stand to lose each bet.

To its credit the casino at Marina Bay Sands does offer information on the house advantage, the advantage that casinos have over players expressed as a percentage. Yet this information is not prominently dis-played – rather, it is only available at scat-tered kiosks throughout the casino.

It is clear that displaying some form of probabilistic information should be re-quired of casinos. With more salient infor-mation on how much they stand to lose in the long run, gamblers may behave less de-structively.

Given the current literature on the proba-bilistic discount rates of pathological gam-blers, it would be reasonable to conduct experiments on the effect of different types of displayed probabilistic information on the discount rates of frequent gamblers. The results of such experiments could in-form the process of crafting more effective behavioral safeguards in the form of patron education.

Apart from probabilistic discounting and odds displays, there is a host of other ways behavioral economics can inform the crea-tion of fairer and more effective casino poli-cies. These policies do not necessarily have to be behavioral safeguards. A thorough consideration of behavioral economics is-sues can benefit the design of pricing and command safeguards.

Concepts in behavioral economics sug-gest that the one hundred dollar levy for citizens and permanent residents could

actually be doing more harm to the people it is intended to protect. Having paid the levy, a person may feel obliged to win it back by gambling more than he or she oth-erwise would. This tendency is described by the loss-averse nature of humans and their vulnerability to the sunk-cost fallacy.

Certain practices by casinos prey on the “gambler’s fallacy,” the irrational tenden-cies to see patterns where there are none. When it comes to casino games, each round of wagering is a statistically independent event. Yet many gamblers misunderstand statistical independence and tend to feel that past outcomes have an effect on future ones. Upon seeing seven outcomes of black on a roulette table, a gambler may feel the chances of red increases for the eighth out-come. Such irrational dispositions are en-couraged by the practice of prominently displaying recent histories of roulette out-comes. The same can be said for games such as Sic bo where displaying the historical re-sults of dice rolls is common in casinos. The gambler’s fallacy encourages a false sense of empowerment. Certain practices in ca-sinos encourage this fallacy which in turn may cause a person to gamble more than he otherwise would.

The implementation of behavioral safe-guards in casinos can be seen as an exten-sion of Richard Thaler and Cass Sunstein’s idea of “libertarian paternalism.” Behav-ioral safeguards are liberty preserving in that they allow individuals the freedom to choose or reject certain courses of ac-tion. Yet they are paternalistic in that they influence people to make better decisions. We may find that when dealing with gam-blers, egging them on to make better deci-sions is more effective than commanding them to do so, or setting a higher price on worse decisions. Better gambling decisions would undoubtedly mean lower revenues for casinos. Yet it could be argued that this tradeoff is less pronounced in Singapore given that the effective tax rate on casinos is much lower than in most other countries. A discussion on this issue however, is beyond the scope of this piece.

The battle to minimize social costs should not end with the creation and enforcement of the current set of social safeguards. It is very clear that behavioral economics has much to offer the policymaking process of mitigating these social costs. Voluntary experiments should be conducted to test hypotheses regarding the decision making processes of gamblers and their responses to various types of information about odds and expected earnings. In doing so, there is not much to lose but plenty to gain, a gam-ble surely worth taking.


Spring 2012 11

I N T E R V I E W

Ricardo A. M. R. Reis is a professor of economics at Columbia University. His main area of research is macroeconomics, both theoretical and applied, and some of his past work has focused on understanding why people are inattentive, why information spreads slowly, inflation dynamics, build-ing better measures of inflation, unconventional monetary policy, and the evaluation of fiscal stimulus programs. He is a founding member of the blog The Portuguese Economy, and writes weekly in Portuguese for Dinheiro Vivo, which comes out with Jornal de Notícias and Diário de Notícias.

Q: you are part of a group of European economists called the Euro-nomics group and this group has been a vocal advocate for solutions to the crisis. Can you briefly relate how the team came together?

Sure, the reason it came together was that several of us had been

going to conferences a little bit everywhere to talk about problems of particular countries and the eurozone as a whole. So as we noticed that we were bumping into each other giving talks, and as we had some debates in this conference, we thought, wouldn’t it be fun if we started having this regularly and talking regularly? And so we had an initial meeting at Columbia by the Program for Economic Research (PER), where we met for a Sunday. We chatted for a little bit about what were the problems and how the situation in Europe was evolv-ing. Then we started meeting regularly via Skype and discussing the situation, and from that, we wondered ‘Why don’t we propose some solutions, since we know we have a sense of what’s going on?’ So we merged that way, somewhat spontaneous insofar as just the few people that kept on meeting each other in conferences and discuss-ing the problems of Europe with each one of us understanding one particular country well and then wanting to understand what’s go-ing on in the other countries. Then going from there to, if we think we know what the problem is here, can we create solutions to them?

Q: you proposed “European Safe Bonds” as part of a possible

solution to the current eurozone crisis on the editorial pages of the Wall Street Journal. Can you explain what they are and how they would ameliorate the crisis in Europe?

So we tried to think of the crisis beyond the easy diagnostics that

you can read in most of the newspapers, and I think our starting point was: you can point to the fact that some regions in Europe have competitiveness problems; you can point to some regions of Europe which have public finance problems; you can point to the weakness of some of the banking sectors in Europe. The problem when you point to them is that regions in the U.S. suffer from exactly the same problems. There are quite a few states in the U.S. – West Virginia, Michigan – which have been in clear slumps that have lasted for a decade or more. You have regions in the U.S. that have clear public finance problems, with pensions about to blow up, not to mention of course California, whose public finances look absolutely dread-ful. You have certainly a banking system in the U.S. that took a very

large hit in 2008 and which have quite a few institutions in trouble. So what it is that makes it so special that Europe is in trouble, espe-cially once you realize that, when you look at the aggregate indica-tors of the eurozone as a whole, they don’t really look bad compared to the U.S.—if anything, in most of them, Europe, up until just a few months ago, was growing faster, had lower unemployment than the

U.S., and had a trade balance unlike the massive deficit that is in the U.S. So the difficulty with most of the things you read on the head-lines is that they sound right, then you find yourself asking, yes, but if that’s right, then why not in the U.S.?

We started looking for what was unique about Europe that led to the current problems. One of the main things that is unique is that banks, European banks, are much more fragmented than U.S. banks, not just in terms of their domain of operations but especially in terms of their portfolio holdings. What I mean by that is that we see Euro-pean banks hold a tremendous amount of their particular country’s debt on their books. We do not see California banks holding a lot of California municipal debt, yet when you look at the typical Portu-

Bonds, European Safe BondsAn Interview with Ricardo Reis

So the difficulty with most of the things you read on the headlines is that they sound right, then you find yourself asking, yes, but if that’s

right, then why not in the U.S.?


12 Spring 2012

guese or Greek bank, a very large portion of their balance sheet was committed to government bonds of Portugal or Greece respectively. And so why is that? The reason is threefold. The reasons are, one, inadequate banking regulations that encouraged this, in particular when it came to establishing capital ratios – that is, requiring that against some assets or capital set aside because of risk. Well, sover-eign debt was treated as all being equally riskless. Even if the markets were saying that the probability of default was close to 99%, it would still be the case that for purposes of setting capital aside for banking regulations, Greek banks had to set zero capital aside against Greek debt, because they were treated as 100% riskless – when in fact they were 99% sure to default. So that was an immediate problem. Sec-ond, the European Central Bank (ECB) was treating all of the sov-ereign debt as being equal when it came to accepting collateral for its loans. And then thirdly, of course, individual countries had a lot of sway because of the fragmented regulation over pressuring the banks of their countries to hold their bonds.

Having realized that this was a big part of why European banks looked so different, we then saw that this was, in some ways, at the heart or the root of the crisis. What has happened in the crisis is that if you have doubts about the solvency of a sovereign, as you see that it’s very likely that Greece is going to default, then you realize imme-diately that if Greece defaults then the Greek banks are going to de-fault, because they’re holding so much Greek debt. Well if the Greek banks go bust, we know of course that, because of explicit deposit insurance or just because it is the norm for sovereigns to bail out the banks instead of letting the whole banking system collapse, the col-lapse of the Greek banks comes with a lot of extra public spending from the Greek government. But that of course leads to or confirms the initial fears that the Greek sovereign will be insolvent, and so you’re stuck in what we called the “diabolic loop” where fears about the solvency of the state becomes self-fulfilling because of this high concentration in the banking sector. So how does one break from the loop? What one needs to do is to move the portfolios of these banks away from their local sovereigns and to do so, one needs to remove the inadequate regulations. What we especially need to do is supply these banks with another asset they can hold which is deemed safe.

Second, another feature of the crisis that was important was that, when Spanish bonds were perceived as safe as German bonds, there was a big capital outflow from Germany toward Spain, because in-vestment opportunities in Spain were good, and a lot of Germans wanted to buy their retirement homes in Spain. However, whenever you have a crisis like this, even if the crisis is somewhat unrelated to what’s going on in Europe but leads to an increase in risk aversion, what you’re going to have is a massive capital outflow, and these very large movements of capital between regions lead to current account imbalances and precipitate crises as we’ve learned to ap-preciate over the last twenty to thirty years of experience with Latin

America. Again, we wanted to have a structure such that these flows, which are fairly natural over some time when markets freeze and in-vestors run for safe assets, did not have the regional component that they did with the current European financial architecture.

So what was the answer to all of these challenges? The answer we thought was the creation of European Safe Bonds. European Safe Bonds are not guaranteed by the joint taxation power, one. Two, Eu-ropean Safe Bonds come with a closely related cousin in their crea-tion, which is what we call European Junior Bonds, which are much riskier than European Safety Bonds in that they don’t have any na-tionality attached to them. Whenever there are big switches in what risk investors want to have, they can switch between European Safe Bonds and these junior bonds, which are both European bonds, and therefore do not lead to any geographic movements in capital and capital flow imbalances.

Q: how are European Safe Bonds and European Junior Bonds created?

A European debt agency of a type could simply buy the debt of different countries up to a certain amount—not all of their debt, but some amounts, say 10, 20 or 30% of GDP, following some very strict rules in terms of how much they can buy of each country—and then it can package them in the following way: the first x-percent of dol-lars paid go to pay for the senior bonds, the European Safe Bonds, and only the remaining go to pay for the junior bonds. On top of that, some money can be set aside so that even if there’s enough on the first payments of the bonds to pay for the European Safe Bonds, then there would be some capital there to ensure that the safe bonds are safe. What this means is that the European Safe Bonds would be extremely safe for three reasons. They’d be safe because there would be a diversified pool of sovereign debt of different European countries, that is, sometimes Greek bonds would be doing poorly when German bonds are doing well, and so just by pooling them together, you’d lower the risk of the whole pool. Second, because they are the first to get paid, that is, that they’re senior, on account of that, it would require a collapse of Portugal, Greece, Spain, and part of Italy for the European Safe Bonds not to pay in full its investors. And third, because of the capital set aside, even that’s very unlikely to happen. By our calculations, the European Safe Bonds would not pay their investors in full about once every thousand years, which of course you should take with a tremendous amount of skepticism. You can divide that by ten if you want, but that still seems pretty safe to us. The junior claim is the junior bond I talked about earlier.

Q: Some have controversially suggested that the European Union

member states ought to issue their own super-bonds – Eurobonds – as a way to support distressed eurozone countries. Are “European Safe Bonds” similar to Eurobonds? how are they different?

The big difference is that Eurobonds are about issuing debt at the

European level that the European taxpayers have to collect the taxes to pay, like in the U.S. If the U.S. government issues federal debt for a billion dollars and decides to give the results to the residents of Dallas, Texas, all of the citizens in the U.S., through their taxes, are going to pay off this debt. With the European Safe Bonds, instead, all the European debt agency is doing is buying these debts, that is, when the citizens of Dallas, Texas decide to spend some money there, they have to borrow and the citizens of Dallas, Texas, and their taxation is accountable for paying the bonds. It’s through pooling, capital guaranteeing, and the junior/senior structure that the Europe-an Safe Bonds work, not through taxation power over other citizens. We thought that this was much more realistic in terms of what the European citizens are willing to take, and it is as or more safe, be-

...we see European banks hold a tremendous amount of their particular country’s debt on their books. We do not see California banks

holding a lot of California municipal debt, yet when you look at the typical Portuguese or

Greek bank, a very large portion of their bal-ance sheet was committed to government bonds

of Portugal or Greece


Spring 2012 13

cause, with Eurobonds, while in principle the sovereign can always tax and pay them, by experience, sovereigns do not do that. And two, and more importantly, given the lack of political unity in Europe, if the Eurobond was issued, and tomorrow, it was discovered that the Greeks or Italians or whoever had spent a lot of money and issued a lot of these bonds inappropriately, I wonder indeed whether the oth-er Europeans would be willing to pay the extra taxes. So that type of political maneuvering is not required for the European Safe Bonds.

Q: Would these “European Safe Bonds” alone avert a steep eco-

nomic contraction in Europe? If not, what other actions should governments and international institutions take to avoid deepen-ing the crisis?

The European Safe Bonds are not a magical potion to solve all the

problems of Europe. They’re one part of a strategy to set European institutions on safer ground. I think the most important lesson is that it’s certainly the case that the European Economic Area, by stopping solely at monetary union, was severely incomplete in a way that has led to the crisis. Many have argued that what’s needed there is a fiscal union, and once you have a full monetary and fiscal union, you’ve in fact created a new state, which is where Eurobonds would lead to. Our argument has been that what’s missing in Europe is not a fiscal union. What’s missing is a financial union. What’s missing is a European-wide bond. What’s missing is European-wide regulation

and deposit insurance. What’s missing is a European mechanism to deal with sovereign difficulties, as there are in countries that have to do with institutions of their localities. We think that if all of those are provided, the crisis would very quickly be averted, because you’d be de facto removing these individual problems in Europe. It is im-portant to realize that, for the European Union as a whole, it doesn’t look that bad; it looks better than the U.S. It’s really about these re-gional imbalances. And the reason that these regional differences are causing such havoc in Europe and not in the U.S. is that there’s an element of integration missing, and we think it’s financial. European Safe Bonds are just one of the few things, which we are working on, and are about to propose.

Q: Do you think major public institutions such as the European

Central Bank and the International Monetary Fund (IMF) have re-sponded adequately to the crisis in Europe thus far?

These have been extremely challenging times but not difficult now,

ex post, to point to mistakes in the last year. Ex ante, they had to make difficult choices. The most egregious mistake is on the part of the European ministers, especially at the level of the European Coun-cil, at the level of prime ministers. Whenever I see a picture of An-gela Merkel or Nicolas Sarkozy or other European leaders meeting, I tremble in fear because each one of those meetings has been more disastrous than the previous one. In the midst of this, the ECB has been, relatively, the sane voice when it comes to the European de-bate. The IMF likewise has been extremely useful in the debate and has been producing the most prescient, as well as sensible, voices. But the European Council has been disastrous.

Q: Many have criticized the European Central Bank for its unac-commodating monetary policy decisions during this crisis. Why do you think the bank has been so cautious in its response?

One, I think the ECB deserves the criticism for still not having driv-

en interest rates down to zero. The ECB has been a little too focused on its inflation target and not enough with the amount of trouble that has happened in the economy. Having said that, the criticism that the ECB has not intervened in asset markets is misplaced. The balance sheet of the ECB has increased as much as that of the Fed-eral Reserve. The ECB has bought a ton of sovereign debt of different countries or accepted [sovereign debt] as collateral for loans. To be providing loans to firms at the duration of three months is something the Fed has never done. The ECB has done a lot in this narrative that has the ECB as this shy, timid [institution] versus the Fed being this bold brave institution; this is simply not true. Having said that, the ECB has not been able to go as far as it should; that would have been desirable at different points in time. I think a very important distinc-tion that people need to realize is that the ECB is a much less potent institution than the Fed in two ways. One way is that when the Fed, every time it intervened in 2009, in doing so, by intervening, had to take on a lot of risks. The Fed has a guarantee from the Treasury that if the Fed lost money, then the Treasury would back it up (would recapitalize the Fed). The ECB does not have it, has never had it, and institutionally does not have it at all. If the ECB does interventions to try to save the financial system or the economy and loses money, the ECB has no one to turn to for providing it with those resources. The only thing one can do when one loses money is to print money, which would rapidly lead to extremely high inflation. So the ECB simply does not have this capital backstop. Secondly, the regulations of the ECB are much stricter than the Fed in terms of what the ECB can achieve, in part because it was created with a series of provisions to make sure the ECB did not interfere too much in the domains that the Europeans do not have a lot of political direction. So one, the ECB as an institution can do less, and two, it has no capital backing rela-tive to its obligations.

Q: What do you think were the major design flaws of the Euro-

pean Monetary Union that have contributed to the current crisis? The lack of a financial union, lack of common deposit insurance,

lack of a European-wide safe bond, lack of European regulation, lack of a mechanism to deal with sovereign and public finance problems.

Q: Commentators have voiced several worst-case scenarios for

the eurozone crisis, ranging from the mild to the bizarrely apoca-lyptic. What do you think is the realistic worst case scenario for the current crisis?

It really depends on what you mean by realistic. A scenario where

the euro disappears as a currency is highly unlikely, but that unlike-lihood, which should have been 0.00001% a few years ago, is some-thing like 1% or 2% or maybe even as high as five or ten. I don’t know if 5% is something that comes across as realistic, but it sounds scarily high relative to the consequences of that. So a scenario where the euro collapses, while it’s not certainly the likely scenario, is one that has a probability that is higher than 1%, which qualifies as a worst case without going into Godzilla 8.

Q: Lastly for your current students, can you tell us when you’ll be

coming back to teach at Columbia? This summer. I’m back in the fall teaching Intermediate Macro as

I always do.

It’s through pooling, capital guaranteeing, and the junior/senior structure that the Euro-pean Safe Bonds work, not through taxation

power over other citizens.


14 Spring 2012

Follow the FedThe International Spillovers of U.S. Monetary Policy

Colin Gray

Stanford University

In 1993, John Taylor’s paper “Discre-tion versus Policy Rules in Practice” argued for a simple monetary policy rule on the basis of dynamic stochastic general equilibrium (DSGE) models, and found a strong fit of that rule to recent policy rates used by the Federal Reserve. The rule is specified in Equa-tion (1), where r is the federal funds rate, π is the average quarterly rate of inflation over the past year using the GDP deflator, and y is the percent deviation of GDP from its trend, also called the “output gap”. The simpli-fied “Taylor rule” is noted in Equation (2). Since its introduction, the Taylor rule has widely been regarded as the most flexible and simple monetary rule that exists.

Beginning in the early 2000s, the United States Federal Reserve deviated significantly from this Taylor rule (see Figure 1). Taylor (2007, 2010) argues that this deviation played a significant role in fueling asset bubbles, particu-larly in the housing market. The link between deviations from the Taylor rule and buoyancy in housing markets is further established by Ahrend et al (2008), who link departures from the Taylor rule to changes in home loan volumes, house prices, housing invest-

ment, and construction investment. Admittedly, the magnitude of this ef-fect remains controversial.

While deviations from the Taylor rule may affect domestic markets in signifi-

cant ways, a natural follow-up ques-tion is how domestic monetary policy affects other countries. Even though

there exists a significant literature on international monetary policy and the role of fixed versus flexible exchange rates, there is a surprisingly sparse literature on how the decisions of cen-

tral banks influence the decisions of other central banks. Perhaps the most recent and powerful theory to address

Figure 1: Federal Funds Rate and Rate Implied By Taylor Rule (below)


Spring 2012 15

the issue is the “monetary superpower hypothesis” of Beckworth & Crowe (2011), which argues that the U.S. Fed-eral Reserve has the unique ability to move the direction of international

monetary policy due to its size and the importance of the U.S. dollar as a worldwide reserve currency. The fol-

lowing paper investigates the spillover effects of U.S. monetary policy using panel data from 12 large countries with relatively developed central banks.

A number of researchers have ad-dressed the question of how U.S. mon-etary policy may affect other countries. Among the most widely cited models

are the VAR models of Kim (2000) and related models that focus on the inter-play between the Federal Reserve and the ECB. While Belke & Gross (2005) argue that there exists “little support”

for a “systematic asymmetric leader-follower relationship between the ECB and the Fed” (921), they point out that

since the creation of the Euro in 1999, innovations in the federal funds rate have Granger-caused innovations in the ECB main refinancing operations (MRO) rate and not the other way around. Ehrmann & Fratzcher (2005) and Monticini et al (2011) analyze the responses of international markets’

and ECB interest rates, respectively, to Federal Reserve announcements, and argue that Federal Reserve announce-ments affect both markets.

Perhaps most relevant, Beckworth & Crowe (2011) expands upon the “mon-etary superpower hypothesis” first in-troduced in a working paper by Grilli & Roubini (1995), which expounds the unique position of the Federal Reserve as a world leader in monetary policy. Their data show that a number of de-veloped countries also lowered policy rates when the Federal Reserve did, and find a positive correlation be-tween the deviation from the Taylor rate by the U.S. and the eurozone. Fi-nally, they establish “a close relation-ship between the stance of U.S. mon-etary policy and the growth of foreign exchange reserves” (15).

This research studies the “monetary superpower hypothesis” using an al-ternative methodology. My data and methodology corroborate their find-ings.

While the extended form of this re-search specifies a rational expectations DSGE model off of which to base my hypothesis, the tenants of my hypoth-esis are basic results of standard two-country Mundell-Fleming models. In the interest of brevity, I qualitatively state the expectations and intuition that these models share.

Suppose there exist a domestic and a foreign country that international investors see as roughly comparable. Consider an unexpected fall in the monetary policy rate of the domestic country. The foreign country expects to see a movement of investments from the domestic country with low inter-est rates into their own country, and an accompanying appreciation of the foreign currency that may have del-eterious economic effects. To counter these effects, the foreign central bank can take a combination of the follow-ing three actions:

1. Lower the domestic monetary pol-icy rate.

2. Build up stocks of the domestic country’s currency to induce relative depreciation of their own currency by expanding foreign currency reserve

Equation 1: r=π+0.5y+0.5(π-2)+2Equation 2: r=1+0.5*y+1.5*π

Deviations from the Taylor Rule for Large Economies (Figure 3.)

Figure 2: Deviation from the Taylor Rule for the United States (see below)


16 Spring 2012

holdings.3. Institute capital controls.Because the period I use in my sam-

ple (1980Q1-2008Q2) is known to be

a period of few to no capital controls among developed countries, I do not consider option [3]. With regards to [1] and [2], testable hypotheses exist. All

else fixed, I expect the foreign country to lower monetary policy rates and/or build up foreign currency reserves when the domestic country lowers its monetary policy rate below a “stand-ard” value for economic conditions, such as the Taylor rule. If the foreign country does not take these

The majority of the data I use comes from Datastream. I pull data in the for-

mat and frequency available (quarter-ly, monthly, or daily) and take quarter-ly averages. This dataset of quarterly averages contains data on published

policy rate targets, GDP gaps, infla-tion, Taylor rule rates (calculated using GDP gaps and inflation), deviations from the Taylor rule (called “gaps” in my dataset), the level of foreign cur-rency reserves measured in U.S. dol-lar value, and the exchange rate. As mentioned before, the exchange rate is measured as the amount of foreign currency worth one U.S. dollar on in-

ternational markets such that a reduc-tion in this value signals currency ap-preciation and vice versa.

I have full data for the following

countries: Canada, the United King-dom, Australia, China, Indonesia, South Korea, Norway, Brazil, Den-mark, Israel, New Zealand, and the eu-rozone. I use all available data for each country, going as far back as 1980.

(1) Do foreign countries lower mon-etary policy rates, expand foreign currency reserve volumes, and/or ob-serve currency appreciation when the U.S. Federal Reserve sets rates “too low”?

Figure 2 shows a graph of U.S. devia-tions from the Taylor rule since 1980. A value of zero indicates no deviation from the Taylor rule, while a negative value indicates the policy rate is lower than the Taylor rule suggests, and a positive value indicates the opposite. As we see, the U.S. Federal Reserve went “too low” in the early 1990’s and between 2002 and 2006.

Figure 3 shows the same deviation from the standard Taylor rule of the countries for which data are available. Dotted vertical lines indicate the peri-ods in which the U.S. Federal Reserve went “too low”. Out of 12 countries, 8 go “too low” in the 2002-2006 period, and most countries show significant reductions in Taylor rule deviations over this period even if policy rates were not below the Taylor rule.

Scatter plots of the U.S. deviation from the Taylor rule (vertical axis) against each country’s deviation from the Taylor rule (horizontal axis) tend

to show a strong positive correlation, suggesting that countries are indeed deviating from the Taylor rule in the same direction as the Federal Reserve

Foreign Currency Reserves versus U.S. Deviations from the Taylor Rule (Figure 5.)

All else fixed, I expect the for-eign country to lower mon-

etary policy rates and/or build up foreign currency reserves when the domestic country lowers its monetary policy

rate below a “standard” value for economic conditions,

such as the Taylor rule. If the foreign country does not take

these, I expect foreign cur-rency to appreciate.

Deviations of Large Countries from U.S. Taylor Rule (Figure 4.)


Spring 2012 17

(see Figure 4).As an important aside, the addition

of the U.S. deviation from the Taylor

rule to a given country’s deviation from the Taylor rule generally adds 10-25% explanatory power (judging by the adjusted R-squared) and is statisti-cally significant in the positive direc-tion at the 5% level, according to t and F statistics. That is, we see added em-pirical accuracy and significance if we assume countries follow the modified Taylor rule in Equation (3), instead of the same rule without the U.S. Taylor rule deviation term. In contrast, the addition of an exchange rate term to these countries’ Taylor rules adds little to no explanatory power and is either not statistically significant at the 5% level, or is less so than the U.S. Taylor rule deviation. This finding suggests that central banks may be consistently considering how U.S. monetary policy is deviating from trends when making policy rate decisions.

The effect of the U.S. policy rate on other countries’ policy rates is evident in a fixed effects panel regression. Un-fortunately, the relative importance of the U.S. deviation from the Taylor rule versus the policy rate level is difficult to establish. The reason behind this is the strong positive correlation between the U.S. policy rate level and the U.S. deviation from the Taylor rule. Statisti-cally, then, it is difficult to determine which variable has the most significant effect, as regressions including both variables result in high standard errors and therefore lack statistical signifi-

cance for both coefficients. Regardless of whether policy rate levels or devia-tions from the Taylor rule are more im-

portant in influencing other countries’ interest rate decisions, we can study the effect of U.S. monetary policy on other countries’ monetary policy in broader terms.

Regression 1 confirms the importance of the U.S. policy rate in international monetary policy decisions. The de-pendent variable is the country’s mon-etary policy interest rate. The variable of interest is the U.S. federal funds rate. In order to control for global trends, I create a policy control variable con-sisting of the average policy rate of the 11 other countries in my dataset, excluding the U.S. and the country of interest. I control for the GDP gap, in-flation, and foreign currency reserves. Due to the delayed effects of monetary policy and the relative unimportance of currency reserves relative to the policy rate, any added endogeneity bias should be overwhelmed by the prevention of omitted variable bias for these variables. Using country fixed effects and heteroskedasticity-robust standard errors, the resulting regres-sion model is Regression 1.

Because of the existence of first order serial correlation in this regression, I use a General Least Squares (GLS) method. My findings are robust to an Ordinary Least Squares (OLS) fixed effects regression and a panel data Prais-Winsten regression.

The coefficient on the U.S. policy rate is positive, as expected, and statisti-

cally significant at the 5% level, even when controlling for worldwide mone-tary policy trends. Furthermore, a one-percentage point shift of U.S. policy has almost the same magnitude of ef-fect as a one-percentage point shift in the average policy rate of worldwide trends. On average, a one-percentage point deviation in the U.S. monetary policy rate causes a similar 0.4-per-centage point deviation in the policy rate of another developed country. These results suggest strong spillo-ver effects of U.S. monetary policy on other central banks’ monetary policies in the expected direction. Indeed, it appears that the U.S. Federal Reserve going “too low” causes other central banks to do the same.

(2) Do foreign reserves increase with U.S. policy rate reductions (and vice versa)?

In order to counteract expected ap-preciation from a negative U.S. mon-etary policy deviation, a central bank

may accumulate foreign currency re-serves for the purpose of targeted de-preciation relative to the U.S. dollar. This hypothesis would appear in the data as a negative relationship between the U.S. deviation from the Taylor rule and the level of foreign currency re-serves for that country. Scatter plots of reserve volumes (y-axis) against U.S. deviations from the Taylor rule (x-ax-is) suggest that this may be the case for many countries (see Figure 5).

This hypothesis can be more rigor-ously tested with a familiar 12-country panel regression. The dependent vari-able is the level of foreign currency re-serves, measured in U.S. dollars. The independent variable of interest is the U.S. deviation from the Taylor rule. Since errors seem to be autocorrelated according to a Drukker (2002) test, I use a heteroskedasticity and autocor-relation robust GLS panel regression similar to that of the last section (see Regression 2).

The data reveal that a U.S. deviation from the Taylor rule has a strong and statistically significant negative effect

Overall, there certainly exists evidence that central banks change reserve volumes in

response to U.S. policy rate movements.

Figure 6:


18 Spring 2012

on foreign currency reserve volumes among large countries with developed central banks. These results are robust to OLS fixed effects and Prais-Winsten specifications. The significance of the U.S. Taylor rule deviation in the re-gression vanishes when we control for the country’s Taylor rule deviation, probably because of high correlation between countries’ Taylor rule devia-

tions and high standard errors. Over-all, there certainly exists evidence that central banks change reserve volumes in response to U.S. policy rate move-ments.

(3) Do foreign currencies appreciate against the dollar along with U.S. pol-icy rate reductions (and vice versa)?

Using the same technique as above, I test in Regression 3 whether exchange

rate appreciation coincides with a negative deviation of the federal funds rate from the Taylor rule, holding constant the country’s monetary policy, reserve levels, and relevant macroeconomic conditions.

I expect a positive coefficient B1, which preciates relative to the U.S. dollar as the U.S. goes “too low”. There is no statisti-cally significant effect in either direction.

Indeed, it appears that a “too low” rate in the U.S. supports a depreciation of foreign curren-cy relative to the U.S. dollar. The result does not coincide with our original hypothesis, and so it seems that a change in the U.S. policy rate does not lead to the expected contempo-raneous change in nominal ex-change rates.

In summary, fixed effect pan-el regression techniques sug-gest the following for the 12 countries considered:

This finding suggests that central banks may be consist-ently considering how U.S. monetary policy is deviating

from trends when making policy rate decisions.


Spring 2012 19

A movement in the U.S. policy rate gen-erally leads to a movement of the country’s policy rate in the same direction. The U.S. lowering policy rates thus causes other countries to lower policy rates, as well.

A movement in the U.S. deviation from the Taylor rule generally leads to a change in foreign currency reserves in the opposite direction. The U.S. going “too low” thus causes other countries

to build up foreign currency reserves, presumably as a means of currency in-tervention to prevent exchange rate ap-preciation.

All else equal, a movement in the U.S. deviation from the Taylor rule has no measurable effect on exchange rates under some regression models. Cor-recting for serial autocorrelation sug-gests that a “too low” U.S. policy rate may actually cause depreciation in the foreign currency.

Using the framework provided by Taylor (1993), Beckworth & Crowe (2011), and Walsh (2010), I expand upon the existing literature by showing the average contemporaneous effects of monetary policy changes on large countries using panel data. Namely, I find that changes in U.S. policy rates affect other countries’ monetary policy rates in the same direction, so a foreign central bank is likely to respond to a “too low” federal funds rate by setting its own policy interest rate “too low”. A central bank is also likely to respond to a “too low” U.S. rate by accumulat-ing foreign reserves, probably to pre-vent significant currency appreciation, in line with the “monetary superpow-er” hypothesis of Beckworth & Crowe (2011). My study finds no positive, sta-tistically significant effects of U.S. devi-ations from the Taylor rule on exchange rates abroad, and possibly even a nega-tive effect, suggesting the puzzling re-sult that a “too low” federal funds rate may lead to disinflation abroad.

As an illustration of how these find-ings may be applied, consider the ECB during the period 2002-2006. When the U.S. Federal Reserve set policy rates lower than the Taylor rule, the ECB did the same. From my various regression techniques, it seems that a standard re-action to a -1.0-percentage point inno-vation in the U.S. monetary policy rate is on average a 0.5-percentage point negative innovation in the monetary policy rate for that country. Including this term in a modified Taylor rule for the ECB may explain a large amount of the ECB’s deviation from the Taylor rule during the 2002-2006 period (see Figure 6). As further application, this study, when viewed in the context of the link between “too low” interest rates and housing bubbles established by Taylor (2007) and Ahrend et al (2008) suggests that U.S. monetary policy spillovers are extremely important in the function of international markets and the preven-tion of the next economic crisis.


20 Spring 2012

Tragedy of the CucumbersSea Cucumber Overfisihing in the Galapagos

Andrew Schein

Stanford University

This paper examines the efficiency ito-day, about 20 years after fishermen began extracting sea cucumbers and examines whether fishermen may be extracting I. fuscus at a rate that is on the inefficient side of the basic catch/stock function. We then evaluate whether the participatory man-agement model used in the Galápagos en-courages good community commons gov-ernance. Lastly, we consider the practical feasibility of individual transferable quotas (ITQs) as a potential means to regulate sea cucumber extraction.

The Galápagos Marine Reserve, extend-ing 40 nautical miles around the archipel-ago, has been a UNESCO world heritage site since 2001. After sea cucumber fisheries off the coast of Ecuador collapsed in early 1990, many fishermen migrated to the Ga-lápagos Islands to meet the continued de-mand for these underwater invertebrates. At the same time, Galápagos fishermen also began extracting sea cucumbers. Cor-ruption stymied early conservation efforts. For instance, in October 1994, Galápagos of-ficials opened an experimental fishing sea-son with 420 authorized divers and a total allowable catch of 550,000 sea cucumbers. Two months later, over 900 divers were fishing, and 8-12 million sea cucumbers had been caught. Currently, the Galápagos Is-lands presents a classic case of the tragedy

of the commons as well as the challenges of commons governance.

Galápagos sea cucumber data is imperfect for two main reasons. First, different zones on various islands have high degrees of var-iation in catch levels. Second, biologists did not do full surveys of sea cucumber densi-ties and population before or even during the first years of the sea cucumber “gold rush” extraction in the 1990s. For this rea-son, we must extrapolate from a very small set of data in order to measure the effects of inefficient overfishing. Nevertheless, a basic stock/catch function indicates that the sea cucumber fisheries are dwindling and endangered. At the end of this section, we discuss anecdotal evidence that indicate un-sustainable fishing practices.

I use these data to consider fishermen’s aggregate effort. Certain events occurred in 2000 and 2002 that exogenously increased sea cucumber stock. First, an El Niño year in 1997-1998 warmed surface water tempera-tures and created optimal conditions for re-production, and the following La Niña year caused cold surface water temperatures, which fostered juvenile sea cucumbers de-velopment. Second, a system of individual transferable quotas (ITQs) implemented in 2001 led to dramatic reductions in catch, partly because fishing vessels mistakenly bought more quota holding rights than they

could use. Both occurrences exogenously increased sea cucumber fishery stocks in the Galápagos Marine Reserve.

I extrapolate from catch (in millions of individual extracted sea cucumbers) and

catch per unit effort (individual cucumbers caught per fisherman per day) to find total effort (catch/CPUE) from 1999 to 2005. For 2002, I use a catch/effort function to model whether current sea cucumber extraction is grossly inefficient. In Figure 3, we see an ef-fort level above the sea cucumber stock re-plenishment rates. Effort level refers to the amount of effort expended by fishermen in


Spring 2012 21

catching cucumbers; it is important in mod-eling resource extraction, because fisher-men who expend more effort will generally catch more sea cucumbers. Thus effort level is a good proxy for the rate of individual cu-cumbers caught per fisherman per day.

In the short run of this model, increas-ing effort yields greater catches and larger profits than lower effort levels do. This in-dividual incentive to overfish is the crux of the classic “tragedy of the commons” problem: private incentives lead fishermen to fish at a much higher level than what is socially optimal. The tragedy of the com-mons is a special case of an externality; in the case of fisheries, the externalized cost is the damage done to the reproductive capac-ity of the common sea cucumber stock. Es-sentially, since future profits derived from

a fisherman restraining his fishing effort do not accrue to that prudent fisherman, all fishermen fish at a higher effort level than is collectively profit-maximizing or socially

optimal.In the Galápagos Is-

lands, increased short-run profits from high effort levels were unsustainable. Fishermen extracted sea cucumbers faster than sea cucumbers could repro-duce and replenish their stock, leading to “stock collapse.” In Figure 4, we see that while the effort level of 2002 probably in-creased total short-run profits, excessive effort level led to subsequent economic losses and exit of many fishermen from

the sea cucumber industry. In fact, decreas-ing total effort level in 2003 is key evidence for this exit. In other words, the “long-run” effects of overfishing only took two to three years to material-ize.

The stock loss predicted by our model can be seen in empirical stud-ies of later years’ sea cucumber density levels and catch per unit ef-fort (CPUE). One indicator of the quickly declining stock is the di-minishing catch per unit effort in each year after 2002 as evidenced by 2005 surveys. The consistently declining returns to effort from 2002 onward suggest that the decline indicates inefficiency. Another indicator of stock loss is that sea cucumber density lev-els plummeted in pre-2003-fishing-season surveys. This alone does not show unsus-

tainable fishing levels; in fact, sustainable extraction may decrease stock density tem-porarily but creates conditions where the

stock grows more quickly than with no ex-traction at all. However, data suggest that density loss was much greater than could be considered sustainable. In the early 1990s, a preliminary survey of the western stretch of the Galápagos Islands found density esti-mates of over 600 individual sea cucumbers per 100 m2. In late 2000s, surveys indicated density levels of about six individuals per 100 m2.

To put this low density in perspective, one should consider minimum average densities before the Galápagos National Park allowed fishermen to undertake any extraction in the area. Sea cucumbers need high density to reproduce, as males eject sperm into the ocean, where currents carry it to nearby females. Estimates of density levels, at which fishermen can sustainably extract sea cucumbers, range from 40 indi-viduals per 100 m2, to 20 individuals per 100 m2, to 11 individuals per 100 m2. These lev-

els, when multiplied by the area in 100 m2 of the fisheries, are close to point “J” in Figure 3. In calculating density levels, biologists at-tempt to find minimum sea cucumber den-sities necessary for stock replenishment. In the 2009 pre-fishing-season surveys, of all macrozones sampled, none reached the minimum reference point of 11 individu-

als per 100m2 necessary to open the fishery. In other words, current sea cucumber numbers are below even liberal estimates of a safe mini-mum stock level. There-fore, the stock is at a critical point, near or at commercial collapse. A stable equilibrium would be represented in Figure 3 by a lower slope of the catch func-tion G(effort, stock), so that it intersected the stock replenishment

function between SMSY and K. Those levels of sustainable yields are shaded on Figure 1. In such a situation, we would expect sta-

In the short run of this mod-el, increasing effort yields greater catches and larger

profits than lower effort lev-els do. This individual incen-tive to overfish is the crux

of the classic “tragedy of the commons” problems: private incentives lead fishermen to fish at a much higher level

than what is socially optimal.

Figure 3

Figure 1: Catch (in millions of individuals) and catch per unit effort (individuals caught per diver per hour) of sea cucumber Isostichopus fuscus 1999–2005


22 Spring 2012

ble CPUE and sea cucumber density levels after a few years; however, we do not see this stability.

Anecdotal evidence reinforces our view that current fishing levels are inefficient. In 2004, fishermen moved to no-take zones (such movement was illegal) to find sea cu-cumbers. They dove deeper, with average diving depth jumping from 14 meters in 2001 to 25 meters in 2004. Moreover, they began extracting imperfect and illegal sub-stitutes for I. fuscus, such as the less valu-able sea cucumber species Stichopus hor-rens.

The Galápagos Islands has a system that could lead to efficient fishing harvests lev-els, in principle. The Participatory Manage-ment Board composed of scientists, fisher-men, tourism representatives, and National Park employees helps set a fishing calendar to promote sustainable fishing harvests. The fishing calendar can close fisheries and set Total Allowable Catch levels to avoid fish-ery collapse. Fishery sustainability is also a matter of efficiency, because fishermen can achieve higher catches at lower levels in the long term if the fisheries do not collapse.

In practice, regulations are not always effective, because fishermen have minimal respect for the regulating body. Fishermen feel that “it is the tourism sector that reaps the benefits of conservation and participa-tory management,” and this sentiment en-genders active hostility towards regulation. Limits on catches have led to violent unrest, including the kidnapping of scientists and Galápagos Giant Tortoises as hostages. Fishermen are also politically powerful. Ac-cording to a report by the Charles Darwin Foundation, fishermen have historically vetoed “any measure designed to reduce

overfishing.” However, the depleted sea cucumber stock has somewhat changed the local attitude toward regulation; fishermen

now view regulation with more openness. Unfortunately, the Galápagos lacks shared norms where politics line up by sector with little shared vision for sustainable develop-ment, accountability of officials to users, and clearly defined boundaries between resource zones, which complicate effective management systems.

The Galápagos Islands can take some much-needed steps towards better com-mons management. “The low probabil-ity of detection, low rates of sanctions, and inappropriate penalties all contribute to undermine locally devised rules,” accord-ing to a Charles Darwin Foundation report on sea cucumber management history. As for commons governance expert Elinor Ostrom’s claim that compliance levels in-crease when the stakeholder group being monitored is included in the group doing the monitoring, fishermen could help the Galápagos National Park Service and Ec-uadorian Navy patrol Galápagos National Park waters. Indeed, one study found that fishermen’s participation in enforcement increased compliance behavior and the per-ception of a regulation’s legitimacy.

In 2009 the Galápagos National Park did not open even one fishery to extraction, due to the low mean densities in sea cucumber fishing zones. Even without a stock recruit-ment, it is unclear how long fishermen will hold out before fishing, despite densities of sea cucumbers near critical “J” level in Figure 3. Practices that further align the interests of individual fishermen with the fishing community’s collective long-term interests would both forestall fishermen

rebellion against the current constrictive co-management process and increase the likelihood that a new recruitment might be better managed. That realignment may take the form of transferable individual quotas, which were tried in 2001 but stopped after that year.

Currently, the fishing sector opposes the use of individual transferrable quotas on the grounds that ITQs will “never yield enough” to cover cash advances that fish-ermen receive before the fishing season to buy equipment. A close reading of this line of logic shows that it is an argument against any TAC that individual fishermen deem too low. In fact, ITQs might take some of the sting out of a TAC that enforced low short-term catch levels. After all, if indi-vidual ITQs did not represent enough catch to cover upfront costs, various fishermen could engage in old-fashioned “Coaseian” trading, where fishermen buy and sell their ITQs to other fishermen. One possible measure to increase the attractiveness of ITQs is for the cooperatives to remove “op-portunistic” fishermen. These “opportun-istic” fishermen are Galápagos men who work as construction workers, as captains on tour boats, or in other primary jobs, and who fish only during the sea cucumber fishing season. Removing them in this way would increase fishermen’s individual al-lowable catch. Individual transferrable quo-tas may seem impractical to enforce, but the style of sea cucumber fishing presents pos-sible solutions to counting and implemen-tation difficulties. The fishing fleet is made up of 446 registered vessels, 85% of which are small wooden or fiberglass boats called “pangas” and “fibras” with outboard en-gines. Larger vessels serve as mother-boats, towing the pangas and fibras to distant fish-ing grounds, storing the catch, and serving as living quarters. Perhaps much of the en-forcement and cucumber counting could occur on the mother ships.

Excessively high effort levels appear to have been grossly inefficient, bringing Ga-lápagos I. fuscus fisheries close to collapse and robbing many Ecuadorians of what could otherwise have been a long-term means of employment. Galápagos cannot rely on good community commons gov-ernance as a substitute for well-enforced regulation. Individual Transferable Quo-tas (ITQ) is one regulatory instrument that Galápagos National Park could use to re-strain effort levels at more efficient levels. If the option of using ITQs could overcome enforcement worries and opposition from fishermen, it could in theory represent an important precedent in the usage of a flex-ible regulatory tool that benefits locals with-out subsidizing migration.

Figure 4


Spring 2012 23

Capital Market Failure Financial Intermediation in China

Laura Fried

Brown University

Financial intermediation is an essential process for achieving healthy growth in any economy. The concept refers to the markets and institutions that pool capital from savers in search of return on assets and allocate it to viable business oppor-tunities in search of financing. Financial intermediation in China is of particular interest because there is a huge pool of savings to invest, approximately $5 tril-lion. However, effectively pooling and allocating a society’s savings requires a robust and developed financial sec-tor that can attract savings and evaluate investment opportunities to determine which should receive financing. Since transitioning to a market economy in 1978, China has been highly successful at aggregating savings—primarily in the form of savings deposits in its four state-owned banks—but largely unsuccessful at assessing business opportunities and allocating capital to growth-enhancing investments. As a result, investors with free capital miss out on high rates of return on savings, and businesses with great ideas are strained for the financial resources necessary to grow and devel-op.

If not to high-return business oppor-tunities, where is all of China’s capital going? The majority of China’s capital is

flowing to the state via the financing of large and inefficient State Owned Enter-prises (SOEs) at the expense of Small to Medium Sized Enterprises (SMEs) in the private sector—a component of the Chi-nese economy which has been the front-

runner contributor to growth over the last decade and has maintained produc-tivity levels double that of the state sec-tor. As a result of SOE restructurings in the 1990s, many smaller state firms were closed down or privatized, leaving only


24 Spring 2012

the largest as SOEs. Alternatively, 80% of SMEs are privately owned. Therefore, SOEs tend to be extremely large firms, while private sector firms are compara-tively much smaller.

As a result of mismanaged financial intermediation, China is experiencing a decline in investment efficiency; banks and capital markets continue to invest in cash-losing state-run businesses. Ac-cording to 2005 state figures, 40% of SOEs reported negative earnings. On the other hand, investment efficiency could increase substantially if capital flowed to high-growth business opportunities in the private sector on a competitive basis. Increasing investment efficiency could al-low China to sustain high growth, while devoting less of its national resources to saving and investment—freeing those resources for consumption and allowing for improvements in standards of living.

Banks are the mainstay of the Chinese

financial system because the vast major-ity of financial assets are bank deposits. The preponderance of bank deposits re-sults from the fact that households, en-terprises, and institutions store the ma-jority of their savings as deposits, instead of other investment vehicles. Data from a 2006 McKinsey report suggests house-holds save about 25% of their income, and over the last two decades have kept 70-80% of their savings in savings depos-its and cash, while keeping much smaller amounts in bonds, equity, or insurance. Firms are similarly dependent on banks since the predominant source of exter-nal finance for businesses is commercial loans. Therefore, banks are the gatekeep-ers of China’s saving and investment: they determine which firms can get fi-nancing and which cannot. Despite their dominant role in the financial system, China’s state-owned banks have failed to effectively lend to healthy firms, which in turn would maximize bank profitabil-ity and broader economic growth.

Chinese banks have not developed the appropriate mechanisms for screening and selecting good firms, nor have they developed the capacity to generate more revenue by charging appropriately high-er rates to riskier borrowers. However,

this problem is not entirely the result of incompetence. Part of the problem is that Chinese banks are accustomed to operat-ing in a planned economy in which in-terest rates, spreads, and term structures were configured by the central bank. It was only in 2004 that the government relaxed mandates on interest rates and gave banks more discretion to set these on their own. Therefore banks never de-veloped experience and know-how in structuring loans and assessing risks. Banks encounter further difficulty in as-sessing firms due to a lack of reliable in-formation that results from discrepancies in accounting practices and a dearth of information-producing firms like credit rating agencies.

Because banks are not adept at assess-ing credit quality of borrowers, banks by default will lend to SOEs, since the consequences of making a bad loan to an SOE are less severe on the individu-al level of the loan officer and the firm level of the bank. A Chinese bank branch manager raised this point in an interview when he described the mentality of bank employees: “If I lend to an SOE and it de-faults, I will not be blamed. But if I make a loan to a privately-owned shoe factory, and it defaults, I will be blamed.” Moreo-ver, if loans to SOEs default or become non-performing, recent history suggests that the national government will not hesitate to purchase bad loans off state bank balance sheets. By contrast, when the privately-owned Guangdong Inter-national Trust and Investment Corpora-tion (GITIC) was no longer able to meet debt obligations in excess of $5 billion due to its speculative involvement in pri-vate sector real estate development, se-curities trading, and silk manufacturing, the state let the trust fail. The bankruptcy left debt-holders with only 12.5% of their original investment. The risk of lending an SOE is effectively zero—regardless of the firm’s fundamentals—because of an implicit government safety net that sup-ports banks lending to the state sector. The GITIC case shows that taking bets on private sector enterprises does not come with the same safety net, and therefore, banks perceive it to be much riskier. Be-cause banks cannot adequately assess private sector firms and will suffer loss-es if private sector investments go bad, banks choose to lend to these firms less.

A crowding out effect resulting from underdeveloped capital markets further drives disproportionate lending to SOEs. 85% of all formal external finance raised by firms in China comes from bank loans and only 15% is raised on debt or equity

markets. In developed economies, the largest and most established firms have the luxury of obtaining their external financing via capital markets, not bank loans, because investors trust public companies enough to finance them di-rectly despite the existence of informa-tional asymmetries between the firm and the public. These firms can thus raise greater amounts of capital with lower overhead because they can forego the fees that banks charge to structure loans and monitor borrowers. In developed markets, large and established firms largely do not compete for bank financ-ing, so commercial loans finance small and medium sized enterprises. How-ever, because capital markets are limited in China, large state-owned firms go to banks for financing and effectively crowd out less established small and medium sized enterprises in the private sector.

As a result of ineffective credit assess-ment capabilities and non-competitive lending practices, China’s banking sys-tem has experienced significant financial difficulties over the last two decades. These problems have imposed large costs on society, evidenced by the large government sponsored bailouts and bank recapitalizations that have taken place. Bloomberg estimates the total cost of these interventions has been $650 bil-lion. On numerous occasions, the Chi-nese government has stepped in to pre-vent non-performing loans (NPLs) from eroding bank asset values and deteriorat-ing bank net worth. NPLs ratios peaked in 2000; 30% of total loans issued by the four largest state-owned banks were con-sidered non-performing, and their total face value was equivalent to 17% of GDP.

Commercial banks are the mainstay of the Chinese financial system: they con-trol the largest pool of capital, and they serve as the primary source of financing for corporations. Despite their size and predominance in the system, they have been highly effective at accumulating savings, but they have failed to allocate these savings efficiently to high-growth business opportunities via lending activ-ities. These failures of financial interme-diation have resulted in banks squander-ing China’s mobile capital by lending to poorly performing state firms, which fre-quently default. These non-performing loans end up being purchased en masse by the government to keep the banking system intact and well-capitalized. This cost to the government and the society at large may be avoided if banks intermedi-ate capital to healthier firms that can use debt financing to grow and develop.

So where is all of China’s capital going, if it is not go-ing to high-return business

opportunities?


Spring 2012 25

Equity markets are a relatively recent phenomenon in China, yet China’s two domestic exchanges in Shenzhen and Shanghai have grown rapidly since their creation in 1990. As of 2005, they have a combined market capitalization that ranks China’s equity market as the 11th largest in the world. Equity finance pro-vides about 14% of all external corporate finance. However, equity markets—like commercial loan markets—have not been effective at awarding capital to firms on a competitive basis. Rather, they have served as another tool to funnel the na-tion’s capital to poorly performing state firms.

Most listing regulations favor state firms and public officials at the expense of private firms and their shareholders. SOEs make up 90% of the approximate-ly 1,500 listed companies, even though SOEs only account for 10% of all indus-trial enterprises. The equity market dis-proportionately finances SOEs because of extensive government involvement in the IPO selection process.

Unlike in the United States, where market forces determine which firms and how many firms go public, in Chi-

na, these variables are controlled by the Central Bank, the State Planning Com-mission, and the State Council Securi-ties Policy Committee. Once the number of IPOs and number of shares are de-termined, they are divided up amongst provinces. Then provincial authorities are responsible for allocating shares and IPOs to interested firms, which are evaluated on their abilities to meet list-ing requirements and their contributions to regional economic objectives. Accord-ing to Zhiwu Chen’s “Capital Markets and Development” (2003), once a firm is selected to receive an IPO permit—often

through a process of lobbying and brib-ing—local officials are highly complicit with firms in committing accounting fraud to ensure that firms meet listing re-quirements. Local officials are willing to commit fraud so that their area SOEs can get access to funding to prop up employ-ment. Successfully bringing firms public also helps the local party establishment to obtain promotions. Local authorities then appoint underwriters to form a syn-dicate, price, and issue the IPO, instead of allowing for a competitive bidding process between multiple underwriters, as in the United States.

Restricting the number of IPOs not only enables SOEs to extract more capi-tal from investors, but also enables local governments to engage in rent-seeking activities. Keeping IPO flow artificially low is designed to push IPO prices ar-tificially high through oversubscription, creating an impression of high demand. This primes SOEs for raising large sums of capital through future seasoned eq-uity offerings (SEOs) at inflated valua-tions. IPO data from the 1990s shows that share prices skyrocketed 732% on aver-age on their first trading day. In this sce-nario, underwriters make a commitment to purchase equity from firms at cheap prices, which means that the firm does not generate as much cash from the IPO as it could if it were priced more accu-rately. However, excitement in the mar-ket bids up the price to absurd multiples, which enables the firm to generate mas-sive amounts of capital when it issues additional shares in the future. Limits on the supply of IPO permits creates an environment ideal for rent seeking. Each province is annually extended an aver-age of only three IPO permits per year. Frequently, local officials hold informal auctions, accept bribes, and issue per-mits to the highest bidder. Many of the strongest firms sidestep this highly polit-icized and inefficient process altogether, choosing to list on the Hong Kong Stock Exchange or another foreign exchange.

Similar to the way in which preferen-tial commercial lending to state firms has resulted in poor loan performance, preferential treatment of SOEs in the IPO selection process has resulted in weak stock market performance, as measured by the relationship between returns and volatility. In the period from 1995-2005, the Shanghai stock market yielded an annual rate of return of 2.5% and experi-enced volatility levels of 25%. Thus, Chi-nese equity markets are an anomaly in that they have low returns and high vola-tility. To put these figures in perspective,

the S&P 500 during the same time period yielded annualized returns of 10.7%, and had an average standard deviation of 13.5%, equivalent to more than four times the return and only slightly more than half the risk of the Shanghai stock market. Overall market value has been another poorly performing indicator. From 2001-2005, the Shanghai index lost half of its value, in spite of national aver-age growth rates of 9%. Such poor stock market performance in a climate of high economic growth indicates that the listed companies do not reflect sectors of the economy that are driving growth. In fact, it indicates the existence of an adverse selection problem: cash-losing, state-run companies are more likely to list on an exchange to gain access to external finance than healthy companies with strong fundamentals and robust cash flows. Chinese equity markets therefore are similar to commercial loan markets in that the parties most adversely af-fected are investors earning low rates of return on savings and private firms that are capital constrained because of insti-tutional bias against them. Beneficiaries are poorly performing state owned firms that obtain capital at an artificially low cost.

Debt capital markets emerge in devel-oped economies as another channel for firms with track records of performance, reputations for being risky or safe, and credit histories based on commercial loans to raise capital directly from the public. They enable firms to forego the costs that come along with bank borrow-ing. However, unlike commercial loan and equity markets, China’s corporate debt market, including commercial pa-per, is ostensibly nonexistent. Corporate bonds represent only 1% of overall GDP, compared to 145% of GDP in the Unit-ed States. Firms that do issue corporate debt, while small in number, tend to be large state owned firms. Corporate bond issuances only account for 1.4% of exter-nal corporate finance raised by Chinese firms, making bank loans and equity the dominant sources of finance by a large margin.

A number of regulatory frameworks designed by the state have made cor-porate bond issuance difficult for firms. Regulation has made the corporate bond approval process extremely lengthy and cumbersome. On average, it takes four-teen to seventeen months for a firm to take a bond to the public. This affects strategic planning for firms, and necessitates that firms make decisions with longer time horizons if they hope to use debt financ-

Part of the problem is that Chinese banks are accustomed

to operating in a planned economy in which inter-

est rates, spreads, and term structures were configured by the central bank. It was only in 2004 that the government

relaxed mandates on interest rates and gave banks more dis-


26 Spring 2012

ing. Furthermore, the Chinese Securities Regulatory Commission (CSRC) has put limits on interest rates that firms can set on corporate debt to no more than 1.4 times nominal bank deposit rates. Since bank rates have been so low, this highly restricts the interest rates that firms can use to price their debt, effectively limit-ing the corporate debt market to well established firms who can issue debt at such a low rate. Lastly, from the inves-tor perspective, government debt is more attractive than corporate debt since inter-est income on government bonds is tax-exempt while corporate bond interest is taxed at 20%.

The most significant obstacles to devel-oping an efficient corporate debt market are large informational asymmetries be-tween firms and the public and the lack of a robust institutional investor com-munity. In countries with developed fi-nancial markets, retail investors rarely purchase corporate bonds directly due to inaccessibility (corporate bonds are usu-ally traded over the counter), denomina-tional barriers, and the need for skilled firm monitoring and credit assessment. However, most retail investors hold them indirectly through investments in mutual funds, insurance funds, and pen-sions. Because there are few institutional investors in China, and those that exist are not large, corporate bonds have had a difficult time generating enough de-mand to be a viable financial instrument. Moreover, China’s small institutional in-vestors are wary of purchasing corporate bonds due to problems of transparency and accounting fraud, which is most common amongst large and state-owned firms. Credit assessment capabilities are the necessary foundation of a thriv-ing debt market, and China continues to lag behind in this area of financial sec-tor development. In developed markets, investors rely on credit rating agencies and credit history to evaluate whether or not to lend to a firm, and at what cost. Chinese banks have had serious issues in pricing and structuring bank loans, and have tended to issue loans at interest

rates clustered around benchmark rates rather than issuing loans at interest rates on a wide spectrum reflecting differences in ability to repay, time to maturity, and collateral posted. Beyond issuing loans at imprecisely determined rates, Chinese banks have done a poor job of storing and disseminating information about borrowers: the rates they were charged, their types of business, and the timeli-ness of repayment. Without this infor-mation, bond instruments are extremely difficult to market. As a result of these informational problems, corporate bond defaults were highly widespread in the 1980s and 1990s, further discouraging the expansion of this market.

While informational asymmetry and transparency problems also affect equity markets, they are not as pronounced as in debt markets since equity holders are willing to accept risk in the hope that they will reap upside benefits. Debt holders do not enjoy the same upside regardless of firm growth, since they receive income streams in fixed amounts. However, debt holders are exposed to downside risks and suffer losses if a firm can no longer cover its liabilities.

China’s inability to intermediate its massive pool of free capital has far-reaching consequences for its broader economic growth and development. The first problem is a decline in investment ef-ficiency. According to the 2006 McKinsey report, since the 1990s, China has experi-enced more than a 50% decline in invest-ment productivity as measured by the units of investment required to produce one unit of output growth. Declining in-vestment efficiency implies that a society must devote a greater share of resources to saving and investment, at the cost of higher consumption and standards of liv-ing, in order to maintain a certain level of growth. The second implication of poor financial intermediation is a higher cost of capital for China’s strongest firms. Ef-fectively, poor financial intermediation is subsidizing China’s weakest firms while adding additional barriers to growth for its strongest players. Despite these hurdles, private firms have managed to grow, but they would likely grow even more if they had fair access to the na-tion’s financial markets. Third, ineffec-tively allocating bank credit to cash-los-ing firms has put enormous pressure on the nation’s banking system as manifest-ed in the high share of non-performing loans. These costs become real to society when the national government is forced to devote billions of dollars to support-ing ailing banks instead of other social,

economic, and military objectives. Simi-larly, granting IPOs to mismanaged state firms has resulted in poorly performing equity markets, which manage to lose value even when the aggregate economy is growing at 8-9% per year. Fourth, the distorted returns on investment caused by poor financial intermediation have adversely affected savers and their abil-ity to earn income on their wealth and save for retirement. Most Chinese savers are left with very few options aside from investments in real estate or near-zero return bank deposits. Equity markets are erratic; debt markets are small; and there are very few financial intermediaries like mutual funds, pension funds, and insur-ance companies. As a result, financial in-come as a share of total income in China remains one of the lowest in the world. The inability to earn capital gains on in-vestments triggers even higher rates of saving as workers fear that they will not be able to grow their savings for retire-ment. Fifth, the overabundance of finan-cial support to SOEs has the implicit ef-fect of devoting more financial resources to antiquated sectors of the economy—primarily in low-tech, low value-added manufacturing industries—at the ex-pense of supporting developments in the high-tech or services sector.

Clearly, inadequate allocation of capi-tal has major repercussions for China as it approaches the complex transition from a high-saving, high-investment, export-oriented economy to a developed economy whose growth is driven by do-mestic demand and consumption. Im-proving financial intermediation is a key part of this transition. In particular, Chi-nese banks and capital markets should adopt a more market-oriented attitude towards the allocation of capital, which uses empirical estimates of risk and re-turn to determine which firms have ac-cess to financing. These reforms would improve the efficiency of financial mar-kets, enable cash-strapped private firms to more easily access capital, and allow Chinese savers to earn higher returns on their investments. All the while, more household income can be made available for consumption. Successfully improv-ing financial intermediation is integral to facilitating China’s emergence as a developed economy on the world stage.

The equity market dispro-portionately finances SOEs because of extensive govern-ment involvement in the IPO

selection process.


Spring 2012 27

Recasting the ModelSpeculation in the Housing Market

Benjamin Ehrlich

Columbia University

The housing asset price bubble between 2005 and 2007 that culminated in the finan-cial crisis of 2008 has resulted in renewed fo-cus on the importance of the housing market in the overall economy. Before the crisis, the securitization of home loans allowed banks to decrease their risk in issuing mortgages by selling them off their balance sheets. Once sold, the loans were repackaged and resold in the form of mortgage-backed collateral-ized debt obligations (CDOs), which were engineered to carry high credit ratings and spread default risk to all holders. A majority of the owners of CDOs were major financial institutions.

With the demise of firms like Bear Stearns and Lehman Brothers, which sent shock-waves through the economy and signaled the beginning of the recession, many people became outraged by the amount of risk these CDOs actually carried. Much has been made of the securitization process, which turned risky assets into AAA-rated CDOs. Scrutiny has also been focused on predatory lending practices, which included offering low teaser rates on adjustable rate mortgages that were issued particularly to those individuals who probably could not afford mortgages of the size they took. Scholarship has also examined the moral hazard problems arising when the risks of issuing mortgages are no longer borne by the issuing bank. Additionally, short-term

investors, who sought to resell houses within a few months of purchasing and thus capital-ize on the rapidity at which home prices were rising, have come under intense criticism. Such buyers, termed “flippers,” might have exacerbated the sustained growth in housing prices and the eventual bust that followed de-clines in demand.

Many people hurt by the recession have

been outraged at the issuing banks’ seeming lack of risk management and screening in the origination of bad loans. When housing prices began to fall, mortgage debtors faced obligations that exceeded the market value of the collateral (i.e. their home). This situation, termed being ‘underwater,’ led to a higher

than expected rate of defaults, including many ‘strategic defaults’ undertaken volun-tarily for economic reasons, thereby creating a positive feedback loop that increased the downward pressure on housing prices. Far from just being a financial problem related to the loss in value of CDOs, the fall in housing prices especially affected those whose home equity depreciated substantially.

Yet looking at this situation only from the perspective of bad risk management in loan granting presents an incomplete picture. Al-though more regulation may be advisable in terms of mortgage origination and credit ratings, perhaps policymakers ought to pay more attention to the incentive structure that households consider when deciding whether or not to take mortgages.

I will outline the dynamics of housing in-vestment in the US economy, summarize the assumptions and input variables that precipi-tated these dynamics, analyze current mod-els being used to explain these dynamics, and examine whether and how the outcomes predicted by the models are supported by the empirical data.

To understand the housing price bubble it is necessary to review the theory of specula-tion bubbles in general. In his 1982 paper Hy-man Minsky posited that asset price bubbles begin with a period of increased optimism in a specific sector, leading to high profitability


28 Spring 2012

forecasts, which are confirmed by rising as-set prices as investors scramble to invest. This “euphoria,” leads to overtrading, a situation in which: (1) whole groups invest for a specu-lative purpose; (2) excessive optimism con-tinues to grow; and (3) banks show a greater willingness to lend money, given the increas-ing profitability of investments. Only when the optimism decreases, generally due to a

reduction in profitability forecasts, does the bubble burst and asset prices fall (Bochenek, 2011).

In the housing market, increasing profit-ability is realized through escalating home prices. During the period between 2000 and 2006, housing prices were rising nationally at an extremely fast pace. Indeed, from January 2000 to April 2006, when the Case-Shiller 20-City Home Price Index (see Figure 1) peaked, the average monthly growth in home prices

was an astronomical 97 basis points. This equates to an average yearly growth of 11.64%. For a homeowner this meant that the value of a home effectively doubled from 2000 to year end 2005. Compared with the period between 1987 and 2000 the average monthly increase in home prices was 30 basis points. This sharp surge in the growth rate of home prices led to the increased optimism predicted by Minsky’s theory.

Optimism needs to be matched by an in-creased availability of credit that allows for increased investment in the sector that is now perceived as profitable. To find evidence of

the increased availability of credit, one can examine the declining interest rate on 30-Year Conventional Mortgages. Over the period from the 1st Quarter of 2000 to the 2nd Quar-ter of 2006, when housing prices were peak-ing, the average interest rate on a 30-Year Conventional Mortgage in the US fell nearly 20% to a rate of 6.6%. This was matched by a peak-to-peak decline in the 1-Year Adjust-

able Rate Mortgage Average in the US. This demonstrates a secular decline in the cost of borrowing over this period of time which allowed for increased loan origination.

One factor that Bayar and Neilson (2010c) identify in their microeconom-ic model as being equally important

to an increase in housing investment is the availability of high loan-to-value (LTV) mort-gages. LTV serves as a limit on how much of a home’s price can be borrowed through a mortgage and how much money needs to be paid as a down payment. By 1970, the stand-ards first set out by the Federal Reserve Act of 1913 had been relaxed from 50% to a 90% LTV ratio. In other words, one could now borrow up to 90% of a home’s value. By 1997, the ratio had actually risen to 125%, which

meant that a home-buyer could use mul-tiple mortgages to borrow not only the full current price of the home, but also its expected future value. Coupled with rising home prices, the increase in avail-ability of high LTV mortgages resulted in an increase in the total value of credit given and invested in hous-

ing (Bayar & Neilson, 2010c).One question arising from this discussion is

how the availability of high LTV ratio mort-gages is linked to speculation. The less mon-ey one needs to put down to buy a house, the more expensive a house one can afford, as-suming one can meet the monthly mortgage payments. The ability to buy a larger house meant that a homeowner could effectively in-vest more in the housing sector which, given the housing asset price bubble, would yield larger profits when the house was sold. In other words, high LTV mortgages allow for increased exposure to housing, which one

would pursue when driven by the expecta-tion of above-average returns.

To demonstrate how this would affect the preferences of a household in spending their earnings, Bayar and Neilson created a two good model. The two goods they chose were housing investment (h) and consump-tion spending (c). Housing investment re-fers to the money put into buying, renting, renovating, or even buying a second house. Consumption spending refers to the basket of goods a household might purchase, which is consumed over the period of the model. In this model, a household aims to maximize a normal utility function, u(h, c), over the pe-riod of the model. To simplify the model, two other assumptions must be made: that the model covers one period; and that no savings or bequests are considered, so that all income is spent. This makes the model static, which simplifies the mathematics behind it.

The theory of the model is based on the ability to borrow against the future value of a house and not, as had been the situation in the past, the current value of the house. This ability only exists where high LTV mortgages are available, as was the case during the run-up to the financial crisis.

In a situation in which the future values of homes are rising and households have the ability to borrow against those future values, the budget constraint can shift outward, as previously discussed, which allows house-holds to consume more of both goods than originally possible. This ability to borrow against the future value of homes makes housing investment relatively cheaper at the margin. However, once the outer borrowing constraint becomes binding, this is no longer the case.

At this point further increases in the future value of homes cannot increase borrowing (as consumers are already constrained by their outer budget constraint), leading to lower demand for housing and increased demand for consumption goods. The reason this re-sult is so important is that it illustrates the de-crease in demand that precedes the burst of the housing bubble. Rather than demand for housing continuing as home values continue to rise, at some point demand for housing in-vestment is curtailed by this borrowing limit

The reduction in housing demand that comes once the outer budget constraint is binding, despite continuing increases in fu-ture value of the house, pf, is one of the most important conclusions of the model. There are two main “regions” of expansion that have differing outcomes in terms of the be-havior of households. In the first, increases in the growth of rf lead to a reduction in the ef-fective price of housing, so demand increases. This continues until the household reaches its limit on borrowing.


Spring 2012 29

At this poin, the second region of expan-sion begins. In this region as pf continues to increase, which reduces the effective price of housing, consumers curtail their demand for housing and begin to demand more con-sumption goods, because on the margin both products are relatively the same price. The reason for this is that once a household has obtained the maximum amount of credit it could possibly get given its income level, in-creases in pf actually allow for a household to

need less housing investment to achieve the maximum amount of borrowing.

One requirement for this expansion is that the future value of homes rises faster than the interest rate, such that pf > p0 (1 + i) is true. p0 (1 + i) is the current price of the home mul-tiplied by the interest rate over the period, i.e. the amount of return one gets on saving all the money they spend on housing invest-ment. If the future value of a home is greater than this, then one is incentivized to invest in housing. Once that outer budget constraint becomes binding, households would begin to downsize their housing investments and con-sume more consumption goods. They cannot pay off their debts if the future value of their home begins to decrease. In a situation like this, the household is consuming more con-sumer goods than their income would nor-mally allow (i.e. c > y).

The reduction in housing demand while the future value of houses continues to rise can be corroborated empirically by examin-ing the quarterly changes in the Case-Shiller 20-City Home Price Index and the changes taking place in Real Private Residential Fixed Investment (RPRFI) (see Figure 3). Despite

having a strong positive correlation between 2000 and 2011 (Corr=0.796), in the period be-ginning in 4th Quarter of 2005, RPRFI begins to decline before housing prices. It was not until the 3rd Quarter of 2006 that the Case-Shiller Index began to experience declines. By this time, the RPRFI had already declined by 11% from its 3rd Quarter 2005 high. What this shows is that demand for housing invest-ment was decreasing over this period of time, while housing prices continued to rise by

2.1% nationally.The importance of this data

is that it links to the eventual bust of the housing bubble. Once demand begins to de-cline, housing starts began to reflect the lack of demand, with peak-to-peak declines beginning in the 2nd Quarter of 2005. These factors com-bine to put downward pres-sure on housing prices, which then leads to systemic shocks throughout the economy since the future value of homes re-flects the trend of decay in home prices.

When home prices began to decline and consequently the forecasted future price of homes began to fall, those people with high LTV ratio mortgages were more likely to go “underwater,” which incentivizes strategic default-ing. Unsurprisingly, as more people default, the downward

pressures on housing prices are compound-ed, resulting in a positive feedback loop. This makes the problem more and more perva-sive, affecting first the households with the highest leverage to income ratios.

All of the foregoing raises the question of whether there was an increase in leverage as-sumed by households in the time leading up to the financial crisis. With the future value of houses increasing at a higher rate than inter-est rates, housing was seen as a good invest-ment. Thus it makes sense that households would want to take on more leverage to gain increased exposure to the higher returns in the housing market, a result predicted by as-set bubble theory.

One way to show this is by plotting data on Debt Outstanding in the Nonfinancial Sectors against mortgage rates. A clear negative cor-relation between the decay in mortgage rates and increases in the debt taken on by house-holds is clear. The intuition is that a reduction in mortgage rate lowers the cost of funds, which therefore allows for more borrowing.

Still, does this increase in borrowing neces-sarily mean that excessive risk was being tak-en? According to John B. Taylor’s evaluation

of sub-prime lending, “The use of sub-prime mortgages, especially the adjustable rate va-riety…led to excessive risk taking.” The evi-dence Taylor relies upon to substantiate his claim is the fact that as housing prices rose, delinquency and foreclosure rates decreased. However, as housing prices began to decline the reverse became true, and foreclosure and delinquency rates began to rise as the model explained by Bayar and Neilson would sug-gest. The “excessive risk” was in the assump-tion of continued growth in housing market.

As scholars including Taylor, Ben Bernan-ke, and Karl E. Case have noted, in the time leading up to the financial crisis, the Govern-ment pursued monetary policy aimed at in-centivizing housing investment. Private resi-dential fixed investment sharply increased during Alan Greenspan’s tenure. Interest rates throughout the economy decreased, and more loans were originated. Still, this causality does not fully explain how mon-etary policies regarding the Federal Funds Rate alone could affect the Bayar and Neilson model.

When the overinvestment in housing as-sets cooled off, one way the Fed could have continued to incentivize housing investment, in order to keep up demand for housing, was to decrease the interest rate. As long as the interest rate is increasing less than the rate at which future home prices are increasing, housing investment continues to be incentiv-ized. However, this points to one of the major shortcomings of monetary policy during the financial crisis. In a situation in which future housing prices are negative, i.e. the future value of a home is expected to be less than the current value of the home, reductions in interest rates do not incentivize housing in-vestment because pf < p0 (1 + i). Thus, dur-ing the period of time in which the Fed was not following the Taylor Rule (Taylor, 2009) and keeping interest rates lower than the rule would have predicted, one of the desired ef-fects, i.e. stabilization of the housing market, did not happen.

Rather than trying to curtail a problem within the greater economy, a more effective solution would be limiting high LTV mort-gages and reforming the incentive structure that affects how households invest. Gunther (2009) writes that a law such as a federally mandated maximum LTV ratio would “cre-ate a cushion of borrower equity” which might go “a long way toward avoiding a repeat” of the financial crisis. The standards that once guarded against such high LTV mortgages need to be reinstated.


30 Spring 2012

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